Payday loans are small loans that are offered with very short terms, usually until the next payday. But because they imply exorbitant interest rates, into the hundreds of oercent in annualized rates, they are severely criticized. Yes, the payday loan industry is thriving, obviously responding to a strong demand. So it would appear that payday loans are welfare improving, or people would not use them, just as much as credit card loans are welfare improving. But many people worry that payday loans, more so than credit card loans, lead borrowers into a vicious cycle of financial dependence. So, should they be regulated out of existence or not?
John Caskey writes that the issue is really about separating two kinds of people. There are first those who fully understand the terms and the cost of the loan, but happen to face a very short term liquidity crisis, having exhausted or having no access to other forms of credit. This can happen to the best people, and happened to me. For them, the payday loan is valuable and clearly welfare enhancing as it fills some market incompleteness. And there are other people who are tempted by the easy cash and immediately face long term issues in paying the loan back. The policy maker would want to prevent the second category to get such loans, but one may ask whether the payday loan industry would want to grant them business as well: they are clearly much riskier. The loaner would want to find a way to discriminate, in particular because this allows to reduce the interest rate on the good borrowers and thus attract more of their business.
But the data indicates the second category is worryingly big. Only one sixth of payday customers borrow once a year or less. And it is estimated 5% of the population would use those loans if they were freely available in every US state, like it is currently the case in some. That would be worrisome. But when Oregon regulated the payday loan industry away, people felt more constrained. And states with payday loans have significantly fewer checks bouncing, although they also have more bankruptcy filings. The paper offers plenty of other examples from the empirical literature, but overall, there is no clear sense whether payday loans are welfare improving or not. Maybe better discrimination of customers is the way to go.