Thursday, February 19, 2009

Subprime borrowers make stupid financial decisions

Much has been written and said about some ill-informed decisions that subprime borrowers have taken with respect to the housing market, in particular taking mortgages that they cannot afford in the longer run. Some of this has been attributed to being ill-informed about the terms of the loans rather than irrationality. Mortgages can be complex contracts with lots of fine print. What about more straightforward financial instruments?

Sumit Agarwal, Paige Skiba and Jeremy Tobacman merge data from a credit card company and a payday loaner, the latter often charging interest rates that annualize to several hundred percents. They notice that people borrow from payday loaners while still having significant liquidity of their credit cards. An amazing two-thirds of those taking a pay-day loan have more than $1000 available on their credit card, and the loan they are taking averages at $300. Over the two week life of such a loan, $52 would have been saved by putting it on the credit card. Considering that payday loans are often repeat businees, we are talking about substancial amounts.

I reported earlier on the puzzle that some people have credit card debt while also having significant amounts in checking accounts. That puzzle could be explained by liquidity needs for transactions that need to be paid by cash. But this new puzzle is really baffling: both credit card and payday loan provide the same service at a very different price, and people use both even if unconstrained. Are people really that stupid? And so many people?

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