Introduction

This report examines the issue of payday lending and whether high-interest loans are predatory. Payday loans typically incur high annual percentage rates (APR), often reaching 391%. The report explores borrower behaviour, focusing on whether borrowers act in their long-term interest or fall into debt traps due to present bias and overoptimism about their ability to repay.

Payday lending background

Payday lending often serves those in financial distress, with over 80% of loans being reborrowed within 30 days. Proponents argue that payday loans provide necessary credit when other options are unavailable. However, critics highlight that many borrowers underestimate their chances of needing repeat loans, leading to high costs over time. Furthermore, 16% of loan sequences end in default, further illustrating the potential risks associated with payday loans.

Experimental design

The research conducted a field experiment with a large payday lender from January to March 2019. Over 1,200 borrowers participated, predicting their likelihood of taking out another payday loan within eight weeks. Participants were offered incentives, including $100 for avoiding further loans, to evaluate whether this changed their behaviour. The data was cross-referenced with borrowing records to assess the accuracy of borrower predictions. Additionally, a survey of experts found they overestimated borrower naivete, predicting a 30-percentage-point gap in underestimation, while the actual gap was only 4%.

Reduced-form empirical results

The study found that the most inexperienced borrowers, those who had taken out three or fewer loans in the prior six months, were overly optimistic, underestimating their likelihood of reborrowing by 20%. However, more experienced borrowers predicted their likelihood of repeat borrowing more accurately, aligning with actual outcomes. Notably, 90% of borrowers expressed a desire for additional motivation to avoid reborrowing, with 54% indicating a strong desire for such support.

Structural estimates of present focus and naivete

The study developed a model to quantify present focus and naivete among borrowers. It found that borrowers, particularly the inexperienced ones, exhibit some level of present bias and overestimate their ability to avoid future loans. Yet, more experienced borrowers are aware of their borrowing patterns and adjust their behaviour accordingly. This suggests that payday loans are not uniformly predatory but may exploit the most vulnerable and inexperienced borrowers.

Welfare and policy implications

The report’s simulations suggest that payday loan bans could reduce overall welfare for borrowers who rely on them for immediate liquidity. However, restrictions on repeat borrowing could improve welfare by encouraging faster repayment and reducing long-term debt traps. Key findings include that while tighter loan size caps and bans reduce borrower welfare, rollover restrictions improve welfare by aligning repayment with long-term borrower preferences. The findings indicate that policy reforms, such as cooling-off periods and rollover restrictions, may better align borrower behaviour with their long-term financial interests.

Conclusion

Experience plays a crucial role in predicting payday borrowing patterns. While less experienced borrowers fall into repeat borrowing more frequently due to overoptimism, experienced borrowers navigate the system more effectively. The study concludes that while payday loans serve an important liquidity function, regulatory reforms are needed to protect less experienced borrowers. The report recommends considering policies that limit repeat borrowing rather than outright bans, which may reduce welfare for those who depend on payday loans. Key statistics include the 20% underestimation of future borrowing by inexperienced borrowers and the 16% default rate on loan sequences.