An Assessment of Consumers’ Use of High-Rate Credit Products

1. An Assessment of Consumers’ Use of High-Rate Credit Products Gregory Elliehausen Division of Research and Statistics Board of Governors of the Federal Reserve System 23 September 2011

2. Outline • Historical background on regulation of high-rate lending • Economic analysis and evidence • Psychological model of the decision process • Studies seeking to determine whether payday loans benefit or harm consumers • Conclusions

3. Consumer credit in the United States • A significant demand for consumer credit developed in the second half of the 19th century as a middle class emerged. • Part of the demand was for credit to finance the purchase of durables (e.g., furniture, sewing machines, pianos). • Demand also existed for small cash loans, which were often used to meet expenses arising from emergencies.

4. Regulation of consumer credit • Usury laws inhibited consumer lending. • Exceptions to usury laws permitted some types of consumer lending: • The time-price doctrine allowed sellers to charge different cash and time prices. • Salary buying, which involved the purchase of an employee’s salary at a discount, was not considered a charge for the use of money. • Usury laws were easily evaded, and violations were widely tolerated.

5. Sources for cash loans • Pawnbrokers provided small, single-payment cash loans for security retained by the lender. • Salary lenders offered instalment loans using wage assignment to collect loan directly from employer if the borrower defaulted. • Chattel lenders offered loans secured by non-purchase household goods.

6. Pawnbroker loans • The borrower deposited assets used as security with the pawnbroker. • Loan size was a fraction of the value of the security. • The borrower pays the full amount of the loan, storage charge, and loan fee to redeem the assets. • Limits to the loan fee were mitigated by the ability to charge for storage.

7. Salary loans • Size between $10 and $35 (about $230 to $810 in 2011 dollars) • Loan size limited by amount of weekly or monthly salary (due to the use of a wage assignment to repay the loan in default) • Term to maturity less than a year • Readily available to consumers whose employers were known to fire employees who agree to wage assignments; otherwise, one or two cosigners were needed.

8. Chattel loans • Size between $10 and $300 (about $230 to $7,000 in 2011 dollars) • Loan size is limited by the value of the borrower’s assets, which were typically furniture. • Term to maturity was usually between several months to a year.

9. Limitations of cash loan products • Pawnbroker loans have the disadvantage that the borrower must have sufficient assets to offer the pawnbroker and forgo their use while the loan is outstanding. • Small loan companies (chattel and salary loan lenders) operated largely outside the law. • Transactions were not transparent. • Legal risk and social stigma added to relatively high cost of originating, servicing, and collecting small loan.

10. Limitations (continued) • The Russell Sage Foundation, the leading consumerist organization advocating reform, noted that some small loan companies were honest businesses (other than violating usury laws). • However, lack of transparency and stigma created opportunities for fraud and abusive practices. • Other small loan companies clearly were predatory.

11. Consumer credit reform • Publicity and enforcement • Ineffective because easily evaded. • Charitable lending • Insufficient because subsidies were required or lenders offered only relatively large loan sizes. • Regulation (Uniform Small Loan Law, 1916) • Rate ceilings that were high enough to attract sufficient capital to meet demand for small loans (42 percent per annum). • Require documentation and disclosure of terms to borrowers. • Licensing.

12. “Experiments” with lower ceilings • Four states reduced rate ceilings some time after adopting the Uniform Small Loan Law’s 42 percent rate ceiling. • Observed effects after rate ceiling reduction • Licensed lenders left the market • Consolidation of offices of remaining lenders • Offered only loans near the maximum loan size • Re-emergence of illegal lenders

13. Illegal lending • Initially some salary lenders continued to operate illegally in low-ceiling states. • In the 1920s, criminal organizations entered the small loan business (first in New York, which did not pass small loan legislation until 1932). • Illegal lenders (not necessarily associated with organized crime) operate in immigrant communities and low-income neighborhoods.

14. Limitation of small loan laws • Very small loan sizes were marginally or not profitable at the 42 percent rate ceiling. • Most salary lenders, which specialized in smaller loan sizes, were driven out of business. • Advocates of reform (Russell Sage Foundation) was aware that smaller loan sizes were unprofitable but made no effort to modify the recommended rate ceiling.

15. Beliefs regarding higher rate ceilings for smaller loans • 42 percent was about the rate at with the burden of interest caused more hardship than the inability to borrow. • Higher rate ceilings for smaller loans would provide lenders with an incentive to split loans. • Most consumers were able to obtain secured loans, which were generally a more suitable product. • Salary lenders were generally disreputable.

16. Markets for smaller size loan products • It seems that we are now facing many of the same questions that arose early in the 20th century when the Uniform Small Loan Law was developed. • The Russell Sage Foundation noted that the case for or against smaller size loan products had not been adequately studied. • The less restrictive regulatory environment at the end of the 20th century provided consumers with a variety of different high-rate borrowing opportunities. • We have some data: The evidence suggestive but far from conclusive.

17. Digression on the FDIC’s small size loan pilot project • The FDIC’s smaller size loan pilot project, though not charitable, seems to be motivated by similar considerations that influenced advocates of charitable lending in the beginning of the 20th century. • The FDIC’s findings appear to be consistent with earlier experience. • The products are at best marginally profitable. • Banks have to make larger size loans or rely on income from selling other products to small dollar loan customers.

18. Economic model of the credit decision

19. Economic model of credit use • Consumers use credit chiefly to finance investment in household durables, which allows them to achieve higher levels of consumption currently and in the future. • A credit transaction is wealth increasing if the present value of benefits less cost is positive. • Because repayment is risky, lenders often require consumers to build equity in the assets being financed. • This requirement may limit consumers’ ability to acquire wealth increasing household durables.

20. Economic model of credit use • Consumers with high rates of return on household investment and limited current resources may benefit from additional credit at higher interest rates. • Such consumers tend to be in early family life cycle stages, have low or moderate incomes, little discretionary income or liquid assets, and are credit constrained. • Payday loan and other high-price credit customers are likely to have characteristics of rationed consumers.

21. High-rate unsecured credit • Finance companies historically were a major source of higher rate unsecured credit. • More recently, credit cards have become the primary source of unsecured credit for many consumers. • While payday loans might rarely if ever make sense for financing household investment directly, payday loans may provide rationed borrowers with a source of emergency funds that allows greater levels of debt-financed investment.

22. High-Rate Credit Decisions • Payday and other high-rate credit products often involve avoiding costs or sometimes taking advantage of unexpected opportunities by credit constrained consumers. • In such situations, costs and benefits can easily be quantified, and the net benefits of using a high-rate credit product can be calculated.

23. Decision rules • Economists use a net present value rule to evaluate decisions: • For small, short-term loans, the net undiscounted value is a heuristic that works about as well as the net present value rule.

24. Decision rules (continued) • Example (Elliehausen and Lawrence 2001): Choice between $200 payday loan to repair car and using public transport until next payday in two weeks. • Net present value is $14.55. • Undiscounted net value is $15.60 ($45.60 sum of cash flows over two weeks less $30 finance charge for payday loan. • The difference is just $1.05 despite a 390 percent Annual Percentage Rate.

25. Household income(percentage distribution)

26. Life-cycle stage(percentage distribution

27. Use of consumer credit(percent)

28. Consumer debt payments to income (percentage distribution)

29. Credit experiences in last five years(percent)

30. Psychological model of the decision process

31. Psychological model of consumers’ decision process “If careful deliberation were defined as comprising all the features of decision making that were included in the study—consideration of alternatives and consequences, discussion with family members, information seeking, as well as concern with price, brand, quality, performance, and special features—the conclusion would emerge that almost all people proceed in a careless way in purchasing large household goods. This conclusion, however, is not justified. Deliberation may be strongly focused on one aspect of the purchase to the exclusion of all others. Therefore, it may be considered as careful deliberation if some but by no means all of the features of problem solving and thinking are present.” —George Katona, Psychological Economics (1975).

32. Urgency of most recent new payday loan • By far most payday loan customers reported that the stimulus for their last payday loan was an unexpected expense that could not be postponed. • Customers either did not have a credit card or, those with cards had high utilization of credit limits. • About half believed that payday loans were their only choice.

33. Consideration of other credit sources before obtaining payday loans

34. Awareness of the price of the most recent payday loan • Two percent of customers reported that they did not know the finance charge. • Three percent of customers reported a finance charge that was to small to be plausible. • Ninety-five percent reported finance charges that were plausible. • Eighty-one percent of customers recalled receiving information on the annual percentage rate. • Sixty-six percent of customers did not recall the rate, and 18.0 percent reported rates that were too low. • Just 16.3 percent of customers reported a rate that was large enough to be plausible.

35. Post-purchase evaluation • Eighty-eight percent of customers were satisfied with their most recent new payday loan. • The most common reasons for satisfaction were the ease and speed of the process. • Eleven percent of customers were dissatisfied. • The most common reason for dissatisfaction was the high cost. • Three percent of customers mentioned difficulty of getting out of debt as a reason for dissatisfied or only somewhat satisfied. • Virtually no one mentioned insufficient or unclear information.

36. Do payday loans increase consumers’ welfare or trap or cause them harm?

37. Frequency of payday loan use • In late 2005, about 2 percent of all consumers reported obtaining a payday loan in the previous 12 months. • The percentage of payday customers is lower than the percentage of consumers that are potentially credit constrained (perhaps 13 to 26 percent). • Twenty-two percent of payday loan customers obtained four or fewer payday loans (including renewals) in the last 12 months. • Thirty percent used 14 or more payday loans in the last 12 months. (Assuming a two-week average term, 14 loans suggests that these consumers owed payday loans for over half of the year.)

38. Do payday loans benefit or harm consumers? • That a considerable percentage of payday loan customers owe payday loans for more than half of the year gives some credibility to the hypothesis that payday loans may lead consumers to ever increasing indebtedness that ultimately ends in default. • If payday loan customers live from paycheck to paycheck with very little discretionary income, even small expenses may cause financial problems and make emergencies a frequent event. Frequent use is not necessarily evidence of a debt trap. • A few researchers have investigated whether availability of payday loans is systematically related to various measures of well-being or financial distress.

39. Community well-being in the aftermath of natural disasters • Morse (2006) compared incidence of foreclosure, mortality, admission to substance abuse treatment programs, and births following natural disasters in California communities that differed in the access to payday loan offices. • She found that areas with payday lenders had fewer foreclosures, deaths, admissions to substance abuse programs and more births—than areas without payday loans. • Morse concluded that despite its high cost, payday lending improve welfare by increasing communities’ resiliency to financial difficulties.

40. Credit availability, debt, and delinquency • Morgan (2007) compared credit availability, amount of debt, and delinquency in states that differed in whether or not payday loans were permitted and where permitted the maximum payday loan size allowed. • He found that financially vulnerable consumers had greater credit availability, equal or greater debt, but equal or less incidence of delinquency. • Morgan argued looser credit constraints without higher delinquency suggest that payday loans may help risky households better manage their finances.

41. Payday loans and bankruptcy • Skiba and Tobacman (2008) and Mayer (2004) examined payday loans role in bankruptcy filing decisions. • Skiba and Tobacman found that Chapter 13 but not Chapter 7 bankruptcy filings were significantly greater for consumers whose application for a payday loan was granted than for those whose applications were rejected. • Petitioners had substantial debts and that payday loans were generally an insignificant fraction of their total obligations. Mayer’s examination of bankruptcy petitions produced similar findings. • Both studies concluded that payday loans probably did not drive most petitioners to bankruptcy but likely did contribute to problems in some cases.

42. Analyses producing results that suggest harm • Meltzer (2011) considered data from states with no payday offices that were adjacent to states that permit payday loans. • He compared measures of distress (e.g., inability to pay bills, delaying medical treatment, doing without a telephone) in border counties with counties with no nearby payday loan offices. • Results indicated greater incidence of distress in border counties than in counties without access to payday loans. • Carrell and Zinman (2008) found access to payday loans was associated with lower performance for some military personnel (first term, non-financial occupations, lower qualifying test scores) but not others.

43. Conclusions

44. Are payday loan customers consumers that may benefit from high-rate credit? • The typical payday loan customer has low or moderate income, is in an early family life-cycle stage, and uses other types of credit. • These characteristics describe consumers that economic model for consumers’ credit decisions predicts may benefit from a relaxation of credit constraints from high-cost, unsecured credit. • Payday loans may be a transitional product for many consumers: As families age and income rises, consumers may become less vulnerable to financial distress.

45. Do payday loan customers behave purposively and intelligently? • Most payday loans are used to pay unexpected expenses or expenses that could not be postponed. • Most customers perceived that they had few if any options to payday loans. • Despite the urgency, the small size of the loan relative to income, and perception that few alternatives were available, many payday loan customers showed signs of deliberation. • Many customers considered other sources of credit before obtaining a payday loan. • Nearly all payday loan customers were aware of the dollar cost of payday loans.

46. Do payday loans increase consumers’ well-being? • Frequent use is not in itself evidence that payday loans trap consumers into ever increasing indebtedness and eventual default. • Some studies suggest that access to payday loans may increase communities’ resiliency to financial difficulties, relax credit constraints without increasing delinquency, and reduce the incidence of financial problems. • Other studies have suggest that access to payday loans may have adverse effects, at least for some types of consumers. • Consumers filing for bankruptcy have substantial debts from other sources: Payday loans are generally insignificant relative to other debts.

47. Do payday loans increase consumers’ well-being? (continued) • The studies examine a variety of outcomes, some of which are quite far removed from payday loan decisions. • That an on average $300 short-term loan used by a very small percentage of the population would affect crime rates, job performance, or check returns seems incredible. • The critical assumption is that differences in outcomes are due to payday loan availability.

48. Do payday loans increase consumers’ well-being? (continued) • State payday loan laws are the product of political processes that determine laws affecting many aspects of the economic and social environment, including availability of other financial services, quality of education services, and types of employment opportunities. • Geographic proximity or accounting for a limited set of economic and social conditions is unlikely to eliminate the effects of other influences on outcomes. • While suggestive, the results of these studies are not entirely convincing.