There are not many easy ways for people with bad credit and few assets to get cash quickly, but payday lenders are one of them. The business model for payday lending is remarkably simple. A person borrows a sum of money in exchange for an agreed deduction from a future paycheck plus a service charge usually around $15 per month for every $100 borrowed. Because the borrowing cost of payday loans is so exceedingly high – the annualized percentage rate (APR) is around 400% – it is often argued that payday lending is a scam that preys upon financially illiterate people.
In an interesting new paper Marianne Bertrand and Adair Morse of the University of Chicago report on a randomized experiment in cooperation with a major payday lender (remarkably) to examine the cognitive biases that may shape payday lending behavior.
In one set of treatments, the researchers experimentally manipulated the information disclosed to borrowers at the time they took out a loan. Some subjects received their cash in an ordinary envelope with a schedule for repayment printed on it. Others received an envelope printed with information intended to present information that dramatically reinforced the true cost of a payday loan. For example, one envelope was printed with a table that displayed the annualized cost of repaying a payday loan (APR over 400%) compared to other loans such as a credit card, a subprime mortgage, and an installment car loan (all with APRs under 20%). The authors find a reduction in future lending among subjects that received the information treatment envelopes – the largest estimated effect was around 11 percent reduced lending.
The authors conclude that payday borrowing behavior reflects cognitive biases. Although the exact psychological process leading to the cognitive error is not ascertainable from the experimental design, the results suggest that people would likely borrow less frequently from payday lenders if they were fully informed about the true cost of repayment. If they don’t borrow from payday lenders, it stands to reason they won’t be able to borrow from anywhere: The population that is borrowing from payday lenders is likely to be shut out of the conventional credit market. This might not be a huge problem if the lending was used to fund leisure spending or non-urgent spending, but plenty of payday borrowers need cash quickly to pay medical bills, repair a car, or pay for groceries. Better information would help to steer people away from obviously bad choices, but it does not help much when the payday lender is the least bad option.