Bankruptcy

Why Do People Use Payday Loans?

By Paige Marta Skiba

Economic models of borrowing and saving offer a hat trick of (not necessarily mutually exclusive) explanations for why people would borrow on high-interest credit like payday loans: 1) Consumers may heavily discount the future, 2) Consumers may experience shocks that cause large, unanticipated variation in their immediate consumptions needs (such as car repair or emergency room visits), and 3) Consumers may have overly rosy forecasts (of either the shocks they will face or their own self-control).

Jeremy Tobacman and I recently put these three theories to real-world data on payday loan borrower behavior and found that behavior is consistent with people being at least partially naïve about their own self-control.

?Hyperbolic discounting? is the most widely used technique of modeling these self-control problems.  An important aspect of hyperbolic discounting is that there are multiple ways consumers can have self-control problems. One may be fully aware of her problem (?sophisticated?) or fully unaware (?naïve?) or somewhere in between.

What is an example of naïve hyperbolic discounting? Suppose a certain guest blogger had set her alarm for 5am every day for the last 8 years, planning to exercise before work?only to snooze until 7am every single day. This is very naïve behavior. She thinks she will have 100% willpower tomorrow, only to wake up every day and suffer the same old self-control issues.

How can we detect sophistication? We?d need to observe a commitment device?some evidence of restrictions on one?s own behavior. An example of a service that provides such devices is www.stickK.com.  stickK (started by who else but behavioral economists) allows you to ?put a contract on yourself? to lose weight, manage debt, etc. Two weeks ago, I turned to stickK for help in battling the ?assistant professor 15??a potential corollary of snoozing through workouts. Each week, I log in to stickK and report my weight. If I don?t meet my goal, I am forced to send money via PayPal to my choice of an ?anti-charity.? Enough anti-charity options are available to meet just about anyone?s political leanings. So far I am batting .500.

What are commitment devices in credit markets? With payday loans, Jeremy and I use behavior on defaults as potential evidence on sophistication. Because defaulting on a payday loan typically precludes future borrowing in the payday loan market, defaulting could be used by consumers who want to ?tie their hands to the mast,? just like Ulysses. We find, however, that default behavior is most consistent with partial naïvete.

Conducting ?welfare analysis? is our next step in ?Payday Loans, Uncertainty and Discounting: Explaining Patterns of Borrowing, Repayment, and Default.? Based on real-world borrowing data, we will estimate whether consumers? overall welfare would be higher in a world with payday loans or without.

In the meantime, let?s hope Charlton Heston doesn?t start sending me Thank You notes. 

Full post as published by Credit Slips on March 18, 2008 (boomark / email).