The Dismal Science

400 Percent APR: Is That Good?

Do people take out payday loans because they’re desperate, or because they don’t understand the terms?

A firm offering payday cash advances

There’s been a lot of finger-pointing lately about who is to blame for the untenable financial circumstances of many American families. Among the usual suspects— Wall Street quants, fly-by-night mortgage brokers, the households themselves —none is an easier target than payday lenders. These storefront loan sharks are portrayed by their detractors as swindlers preying on the desperation and ignorance of the poor. A payday backlash is already well underway— Ohio recently passed legislation capping interest rates at 28 percent per year, and the Military Personnel Act limits interest charged to military personnel and their families to 36 percent. The average payday loan has an annual interest rate of more than 400 percent.

Payday lenders themselves argue that they’re being victimized for providing a critical social service, helping the hard-up put food on the table and cover the rent until their next paychecks. Charging what seem like usurious interest rates, they claim, is the only way to cover the cost of making $100 loans to high-risk borrowers.

If payday lenders really do provide a much-needed financial resource, why deprive Ohioans and American servicemen of this service? A recent study by University of Chicago economists Marianne Bertrand and Adaire Morse suggests there might be a middle ground, by allowing payday lenders to continue making loans but requiring them to better explain their long-term financial cost. In a nationwide experiment, Bertrand and Morse found that providing a clear and tangible description of a loan’s cost reduced the number of applicants choosing to take payday loans by as much as 10 percent. Better information, it turns out, may dissuade borrowers vulnerable to the lure of quick cash while maintaining the option of immediate financing for those truly in need.

An average visitor to a payday loan shop expects to get a loan of around $350. Lenders typically charge a loan fee of $15 for each $100 borrowed, with the principal and interest fee to be repaid at the date of the borrower’s next payday. Since most employees are paid twice a month, a customer who takes out a $100 loan each pay cycle and repays it the following one will have spent nearly $400 over the course of a year, making the annual percentage rate on the loan 400 percent. (By comparison, the APR on most credit card debt is 16 percent; for a subprime loan, it’s 10 percent.)

Before receiving the loan, borrowers sign an agreement that includes a government-mandated disclosure of this stratospheric APR. So it’s natural to wonder why Bertrand and Morse would expect any further information on loan costs to have an impact on the decision of whether or not to take the loan.

The researchers argue that many payday loan customers may not know what an APR is, let alone have any basis for judging whether 400 percent is high or low. (Some states require that applicants sign a waiver confirming that they understand the APR, but they’re certainly not tested for APR comprehension.) So Bertrand and Morse devised three alternative ways of explaining the high cost to borrowers and collaborated with a national chain of payday loan stores to see what effect this additional information might have on prospective payday customers in 77 stores nationwide.  

On randomly selected days, in addition to receiving the usual loan paperwork, borrowers were given the option of participating in a University of Chicago study. (They were given a free magazine subscription for taking part.) The willing participants filled out a short survey on education background, level of self-control (“Do you describe yourself as a planner? Impulsive?”), purpose of the loan, and the number of weeks they expected to need to repay it. Then, instead of getting a standard-issue package with only with the loan due date printed on the front, participants received an envelope with additional information on the cost of the loan.

One group of loan applicants was presented with a table of APRs, listing the cost of payday debt relative to credit cards and subprime mortgages and highlighting the relatively high cost of payday loans relative to these other forms of financing.  

The second group of prospective borrowers in the study received a chart showing the cost of using a $300 payday loan for three months ($270 in interest payments) as compared with credit card debt ($15). Here, Bertrand and Morse tested the thesis that borrowers may view each small loan in isolation, without considering the full toll that payday borrowing takes on their finances. It’s $15 here … $15 there … peanuts in the grand scheme of things (hence the aptly named peanuts effect in behavioral economics). But over a few months, this adds up to real money.

Finally, the economists wanted to assess whether payday borrowers are as hopelessly optimistic about their future finances as the rest of us. Bertrand and Morse presumed that when most prospective borrowers take out a two-week loan, they expect it to be a one-time thing—only to find themselves in the same desperate situation two weeks later. To counteract this misperception, Bertrand and Morse gave a third group a chart showing the average number of times payday loans get refinanced (four out of 10 borrowers refinance at least five times).

Compared with a control group of participants who simply filled out the survey (but never got any extra payday loan info), Bertrand and Morse found that presenting borrowers with a comparison of a payday APR with the APRs on mortgages or credit cards had no effect on borrowing in the months that followed, possibly because these other forms of financing are generally unavailable to payday borrowers anyway and thus not relevant to their decisions. But the borrowers who were given a chart explaining the three-month cost of carrying a payday loan were 10 percent less likely to take a loan during subsequent months. Among those who did take additional loans, the total amount borrowed averaged around $195, as compared with $235 for the control group. The chart showing average borrower refinancing rates had little impact on the fraction of customers taking additional loans but did reduce the amount of future loans among those who continued to borrow. (Unsurprisingly, the effect of better information was greatest for those that rated themselves as cautious planners rather than impulsive spendthrifts.)

So presenting borrowers with a clearer explanation of how costly it will be to carry the loan might save some folks from falling into the payday debt trap. But what about the other 90 percent of borrowers, who even when presented with evidence of the long-term costs still took the loan? For many of these borrowers, no amount of information will deter them. These may be candidates for what Richard Thaler and Cass Sunstein call a “nudge” out of payday borrowing. Economists Dean Karlan and Jonathan Zinman have proposed just such a nudge: mandating a cooling-off period before a payday loan clears to discourage impulsive borrowers (though this runs somewhat counter to the purpose of a payday loan, which is for people who need money now).

A recent policy paper by Michael Barr (now assistant secretary of the treasury for financial institutions), co-authored with behavioral economists Sendhil Mullainathan and Eldar Shafir, puts the payday lending business in the context of the larger problem of a banking sector that doesn’t address the needs of the poor and unbanked. Among their suggestions is a tax credit for banks that provide safe and affordable accounts and lending services for the poor.

All of these ideas recognize that we don’t live in a world of perfectly informed consumers making rational decisions in well-functioning markets. This research and these proposals come at a time when the myth of the rational market has exploded. The White House, meanwhile, is now occupied by an administration that may be willing to use the hand of government—guided by the work of researchers like Bertrand and Morse—to give payday borrowers the information they need to make decisions that serve their own interests rather than those of the finance industry.