Payday loans have been a controversial subject of debate in the U.S. in recent years. Critics of payday loans have focused on the high costs of these loans and have argued for outright payday loan bans. However, we show that payday loans serve an essential insurance purpose even in the presence of these high costs. We are the first to inform the payday loan policy debate in a structural framework by conducting a series of counterfactual policy experiments.
Payday loans are short-term loans, generally for less than $500. They are typically secured by a check provided to the lender, post-dated to the borrower’s next payday. The application process is highly streamlined, and credit criteria minimal—a key attraction of the product is the immediacy with which the borrower can access needed cash. The cost of a payday loan typically ranges from $15 to $22 for a two-week, $100 loan. When expressed as an annual percentage rate (APR), these costs range from 391 percent to 572 percent. Focusing first on the case where the formal filing cost is increased, we can observe that this change leads to a significant decrease in the formal default rate. This is caused by substitution from formal default to payday default as the (unconditional) payday default rate rises. The drop in the formal default rate leads to a decrease in the average bank interest rate as banks require a lower default premium on their loans.
Several banks and credit unions agreed to participate in our study, though only a few had been offering their payday loan alternative for an extended period of time. The largest and most successful program we identified was that offered by the North Carolina State Employees’ Credit Union. Two payday loan providers agreed to participate in our project. One, Valued Services Acquisition Company (VSAC), is a subsidiary of a multiline provider, CompuCredit, which is a publicly traded, broad-based financial services company focused on short-term credit products. The other, Advance America, is the nation’s largest monoline payday loan vendor as measured by the number of advance centres operated.
Payday loans provide a convenient and fast way to access needed money, and for some consumers they are the only available loan source. Their widespread use indicates they fulfil a great need. Although payday loans are marketed as short-term loans, the data suggest, however, that they become longer-term loans for many. With rollovers, the cost of the loan fees can surpass the amount of the original loan in a matter of weeks. As a result, extended payday loans become a financial burden for many consumers. Based on a recent report from the Pew Charitable Trusts, it appears that payday loan customers have a love-hate relationship with this type of financing. The report states that “by almost a three-to-one margin, borrowers favour more regulation of payday loans. In addition, two out of three borrowers say there should be changes to how payday loans work. Despite these concerns, a majority would use the loans again.”24 The challenge for state legislators and the CFPB going forward seems to be this: How should the payday loan industry be regulated to maintain access to short-term loans yet limit or prevent excessive debt?
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