400 Percent APR: Is That Good?
Do people take out payday loans because they're desperate, or because they don't understand the terms?
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.
Ray Fisman is the Lambert Family professor of social enterprise and director of the Social Enterprise Program at the Columbia Business School. He is the co-author, with Tim Sullivan, of The Org: The Underlying Logic of the Office. Follow him on Twitter.
Photograph of a firm offering payday cash advances by Mark Ralston/AFP/Getty Images.