Econ 398 – Proposal 2
28 October 2011
The payday lending industry is a controversial topic in today’s society. There is no doubt
that there is a need for emergency funds for low-income individuals, but many people question
whether payday loans qualify as predatory lending. This paper attempts to answer the question,
does borrowing from payday lenders negatively affect the financial situation of individuals?
Low-income individuals who do not save regularly encounter situations (for example, car
repairs or medical bills) in which they need money and cannot wait until their next paycheck.
Payday lenders fill this need by providing immediate cash, but they charge excessive interest
rates for their service. Charging 390-780% interest on loans made to individuals already in
desperate financial situations simply sends these individuals further into a cycle of perpetual
debt, in which they struggle to simply make the interest payments and late fees on the loans that
they have previously taken out. Thus, they become even more dependent on other sources of
financial support, such as nonprofits and government assistance programs, and drift further from
the desired state of financial stability.
In a monograph on the payday lending industry, Elliehausen (2009) provides a good
description of the industry. A payday loan is a small, single-payment loan that is repayable on
the borrower’s next payday. The customer writes a post-dated check for the amount of the loan
and fee. Typically, payday loans are between $100 and $500 and have a term to maturity of
about 14 days. Fees are commonly between $15 and $20 dollars per $100 borrowed. Because of
the small loan amount and short term to maturity, annual percentage rates for payday loans are
commonly between 390 and 700 percent. The high APRs have led to allegations that payday
loans are predatory. Industry critics often argue that the high interest charges and single-payment
feature of the product make repayment of the debt difficult, trapping many borrowers in a series
of renewals that ultimately lead to insolvency. Payday lenders contend that the product satisfies
credit-constrained consumers’ liquidity needs for short-term credit to manage unexpected
expenses and shortfalls in cash. Although payday loans have a relatively high price, the costs
arising from delinquencies, late payments, and loss of goods or services that such unexpected
events could trigger may be even higher. These contentions need not be mutually exclusive. As
with other credit products, some borrowers may have problems repaying while others are able to
pay on time and receive benefits from the item being financed. Elliehausen concludes that
payday lenders ultimately fulfill a demand in the market and cannot be viewed as inherently
damaging to borrowers.
Payday lending is legal and regulated in 37 states. There are 743 payday lending
locations in Virginia alone. Positively, the great industry concentration should facilitate
consistent store environments and a greater array of available products. A study by DeYoung and
Phillips in 2007 found that as a result of a price ceiling imposed by state law, the benefits of
lower rates as a result of competition for payday borrowers disappeared. Instead, all firms
seemed to implicitly collude around the price ceiling itself. In addition, payday lenders began to
charge higher prices in places with large concentrations of minorities and near military bases.
Today, six payday loan companies control around 20% of all payday lending activity. The larger
payday lenders are characterized by shorter-term loans and more repeat borrowers than other
smaller chains. However, generally payday stores affiliated with a large chain organizations
charge higher prices than single store locations. These chain organizations are also characterized
by a generally lower price for first-time customers and higher prices for repeat customers.
About 5% of the US population has taken out at least one payday loan in their lifetime.
14% of families who withdrew a payday loan within the past year had ever been delinquent on a
payment for any type of loan. An estimated 9 to 14 million customers borrow from payday
lenders each year. The typical payday borrower tends to be characterized as a young adult with a
high school education who is married with children and generally has at least one major credit
card (Logan and Weller, 2009).
A study conducted by Flannery and Samolyk (2005) notes that although consumer
demand for payday loans is very strong, and the industry has grown tremendously, there is much
criticism of the industry. When the fees associated with payday loans are converted to
annualized rates of interest (APRs), they are considered exorbitant. Using proprietary store-level
data provided by two large payday lenders, this article studies store costs and profitability. This
study could be viewed as biased because it was done with cooperation of two payday lenders
who obviously have a stake in the results. It examines how profitability relates to the borrowing
patterns of payday borrowers, default losses, and store characteristics. It also examines how
profitability varies with local economic and demographic conditions. It finds that fixed
operating costs and loan loss rates do justify a large part of the APRs charged on payday loans
but not entirely. Oftentimes, a store’s loan volume is a key determinant of its profitability. It is
also concluded that loan renewals or loans from frequent borrowers are not more profitable than
other loans, which is commonly assumed, but they do contribute to the volume. After
controlling for volume, they find that economic and demographic conditions in neighborhoods
where stores are located do not have a significant effect on profitability, although they can
slightly influence default loss.
Stegman and Faris (2003) find in their study a different result. Payday lenders fulfill the
demand for very small, short-term loans by credit-constrained households. Their article explores
the relationship between the boom in the payday lending industry and short-term consumer credit
in low- and moderate-income neighborhoods. There is special emphasis on the relationship
between common practices within the industry and the high incidence of payday borrowers
trapped in a cycle of debt. Their empirical analysis confirms the necessity for this type of small
short-term loan, but concludes that profitability of the payday lending industry is largely based
on chronic borrowers.
An article by Tobacman and Skiba (2008) explores the relationship between payday loans
and bankruptcy. They match individual-level administrative records on payday borrowing to
public records on personal bankruptcy, and exploit a regression discontinuity to estimate the
causal impact of access to payday loans on bankruptcy filings. Although the average size of a
payday loan in their data is around $300, they find that loan approval for first-time applicants
increases the two-year Chapter 13 bankruptcy filing rate by 2.48 percentage points. They
attribute this relationship to two effects. Firstly, consumers who utilize payday loans are already
financially stressed. Secondly, approved applicants borrow repeatedly on payday loans and
pawn loans, which carry very high interest rates. In their subsample, the cumulative interest
burden from payday and pawn loans amounts to roughly 11% of the total liquid debt interest
burden at the time of bankruptcy filing.
The data I plan to use is from the Survey of Consumer Finances. 2007 was the first time
the survey has asked about payday lending practices. I will be using the Full Public Data set in
Stata format, which contains approximately 5,000 variables.
DeYoung, Robert and Phillips, Ronnie J. “Payday Loan Pricing” Federal Reserve Bank of
Kansas City Economic Research Department (2009). Print.
Elliehausen, Gregory. 2009. “An Analysis of Consumers’ Use of Payday Loans,” Financial
Services Research Program Monograph No. 41, January.
Flannery, Mark, and Samolyk. Katherine, Payday Lending: Do the Costs Justify the Price?. ,
Logan, Amanda and Weller, Christian E. Who Borrows from Payday Lenders? An Analysis of
Newly Available Data 2009
Skiba, Paige Marta and Tobacman, Jeremy. 2008 Do Payday Loans Cause Bankruptcy?
Stegman, Michael A. and Faris, Robert. 2003. “Payday Lending: A Business Model that
Encourages Chronic Borrowing.” Economic Development Quarterly, 17(1): 8-32.