What’s Wrong with Pay Day Loans Anyway?

What’s Wrong with Pay Day Loans Anyway?

The Truth Behind Predatory Lending.

Pay day loans are certainly not new on the financial scene having been first recorded as implemented in the early 1990’s, but this also makes them one of the freshest faces on the scene, and one that is often times a bad word, or frowned upon. So I endeavored to find out whether the stigma behind whether these pay day loans are cruel and wrong financial traps or simply being misused by confused or negligent parties.

The feature of these pay day loans that makes them predatory is almost always said to be their high interest rates, but in any financial loan situation the interest rate is tied to the risk associated with lending money and therefore having to charge a higher interest rate may not always be a bad thing. Another claim is that these pay day loans are aimed at minorities or culturally unstable people, but the numbers show that regardless of race people still flock to these institutions.

That is two separate reasons reasonably disposed of through logic and the removal of these two distractions allows us to hone in on what may be the downfall behind the reputation of pay day loans: rollovers.At a blog hosted by the New York Federal Reserve, Robert DeYoung, Ronald J. Mann, Donald P. Morgan, and Michael R. Strain attempt to answer that question: 

“We show that many elements of the payday lending critique—their “unconscionable” and “spiraling” fees and their “targeting” of minorities—don’t hold up under scrutiny and the weight of evidence. After dispensing with those wrong reasons to object to payday lenders, we focus on a possible right reason: the tendency for some borrowers to roll over loans repeatedly. The key question here is whether the borrowers prone to rollovers are systematically overoptimistic about how quickly they will repay their loan. After reviewing the limited and mixed evidence on that point, we conclude that more research on the causes and consequences of rollovers should come before any wholesale reforms of payday credit.

So if payday loan fees are competitive and don’t spiral, and if lenders don’t target minorities, and if the academic research on the pros and cons of payday credit is so mixed, what’s left in the critique against payday lenders? Rollovers. Payday lenders often pitch their two-week loans as the solution to short-term financial problems, and, true to form, about half of initial loans (those not taken out within fourteen days of a prior loan) are repaid within a month. Potentially more troubling is the twenty percent of new payday loans that are rolled over six times (three months) so the borrower winds up paying more in fees than the original principal.

Critics see these chronic rollovers as proving the need for reform, and in the end it may. A crucial first question, however, is whether the 20 percent of borrowers who roll over repeatedly are being fooled, either by lenders or by themselves, about how quickly they will repay their loan. Behavioral economists have amassed considerable evidence that, contrary to tenets of classical economists, not all people always act in their own best interest; they can make systematic mistakes (“cognitive errors”) that lower their own welfare. If chronic rollovers reflect behavioral problems, capping rollovers would benefit borrowers prone to such problems.

As you can seethe evidence, the logic all match up it is not the loans which are inherently evil, but the capacity for them to be used, or rather abused. This is what gives them such a negative outlook.