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Payday loan regulation and how it affects borrower behavior

Wednesday, September 18, 2013

Twelve million people in the U.S. borrow from payday lenders annually. With unique data from an online payday lender, Justin Tobias and Kevin Mumford used a novel method to see how payday loan regulation affects borrower behavior.

“No one had looked at the effect of payday loan policy and regulation at all. Nobody was looking at the particular policies that states can play with and their potential impacts on borrowers,” says Mumford, assistant professor of economics. “I was a little bit surprised by what I learned along the way.”

Bayesian analysis of payday loans

The two Krannert professors teamed with Mingliang Li, associate professor of economics at the State University of New York at Buffalo, to analyze data associated with approximately 2,500 payday loans originating from 38 different states. The resulting paper, “A Bayesian analysis of payday loans and their regulation,” was recently published in the Journal of Econometrics.

The research was made possible when Mumford met the owner of a business offering payday loans. “I secured the data without knowing what we would do with it.” After considering options, they decided to look at the effect of payday regulations on loan amount, loan duration and loan default.

“Justin, Mingliang and I came up with a structural model for analyzing the key variables of interest. We made some reasonable assumptions in order to provide causal-type answers to questions like:  what is the effect of lowering the interest rate on the amount borrowed and the probability of default?”

Tobias, professor and head of the Department of Economics at the Krannert, says, “We employed Bayesian methods to estimate key model parameters and used those results to predict how state-level policy changes would impact borrower behavior and, ultimately, lender profits. The Bayesian methods really helped to facilitate estimation and inference in this reasonably complicated setting.”

Better than bouncing a check

“Having done this project I have less of a negative view of payday loans,” Mumford says. “The common payday loan was something like $300 and had a term of 14 days. The average borrower paid about $45 in interest.”

“Obviously, that’s a really high interest rate, but it’s not totally out of line with what a bank would charge you for a bounced check. A lot of payday loans have interest charges which are smaller than that. You can see that for someone who has no access to credit, this is better than bouncing a check.”

Key research findings

  • Decreasing the maximum interest rate that may be charged increases the length of time the loan is held and decreases the probability of default. “People were taking longer to pay back their loan if the interest rate was lower. I was a little surprised by that,” Mumford said.
  • Reducing the maximum amount that an individual may borrow decreases the length of time the loan is held and also decreases the probability of default. Despite the lower incidence of default, the net result of such a policy is not attractive for the lender.  “It’s not as profitable,” Mumford says. “Even though they will have some additional defaults, they still make more money by loaning higher amounts.”
  • Requiring the borrowers to repay their entire loan on their next payday (instead of allowing for loan renewals) results in lower lender revenues and an approximate three percent increase in the likelihood of default.
  • Borrowers try to avoid penalties such as court costs and other fees associated with default. Policies with more stringent penalties for default that also lower interest rates may be popular with both borrowers and lenders.

Journal of Econometrics link

You can find the paper with complete findings at the Journal of Econometrics.