Do Payday Loans Cause Bankruptcy?

Anecdotes about the effects of high-interest payday loans abound, but these correlations don't tell us about the causal impact of borrowing at 450% APR. Simply observing payday loan borrowers' in financial distress can't determine which direction the causality goes.

Jeremy Tobacman and I have found a clever way to sort out this causality issue and can answer at least this question: "Do Payday Loans Cause Bankruptcy?" with a decisive "Yes."

How do we do it? Payday loans are approved/denied based on a special credit score (different from a FICO score). Using personal bankruptcy filings as a proxy for financial stress, we compare filing rates  for individuals in Texas who were just barely approved to borrow on payday loans with the rates of those who were just barely denied. These two groups are similar on all other dimensions, except one group got access to payday loans and one didn't. Therefore, any differences in bankruptcy filings rates can be attributed solely to access to payday loans. This "regression-discontinuity approach" is the social-scientists' version of a clinical trial—the gold standard for causal inference.

We find that loan approval for first-time applicants increases the two-year bankruptcy filing rate by 2.48 percentage points (around a 90 percent increase in the bankruptcy filing rate).

How can a small loan (~$300) lead to bankruptcy? There appear to be two components driving this large effect. First, consumers are already financially stressed when they begin borrowing on payday loans. Second, approved applicants borrow repeatedly on payday loans and pawn loans, which carry very high interest rates. (That group that was just barely approved borrowed on average $3000 from one payday lender within two years.) Based on data from US bankruptcy petitions, we calculate that the cumulative interest burden from payday and pawn loans amounts to roughly 10 percent of the total liquid debt interest burden at the time of bankruptcy filing. See "Do Payday Loans Cause Bankruptcy?" for more details.

It is good to keep in mind that standard economic theory suggests that consumer credit, even high-interest credit, can facilitate consumption smoothing (the efficient allocation of capital from good times to bad) to help customers cope with short-term shocks that arise between paychecks.

Jeremy and I will post more on why people would (rationally or otherwise) borrow at 450% APR later this week!

Comments

[Patches]

I think payday loans are usually the “push in the back” to most debtors contemplating Bankruptcy. Most potential bankruptcy clients have multiple payday loans. If they have one, they most likely have 1 to multiple more. It may not be the high interest rate alone driving them into bankruptcy but a combo or a “one-two” punch of high interest rates and collection techniques. The later is what I am seeing as the debtor’s main reason for talking to us. Some have signed post-dated checks to be deposited on the due date. If there is no money in the account the debtors sometimes are in error when they think they will go to jail for writing the NOW nsf check. So of course they don't have the money when it is due, they go back in and refi the note. They are now even deeper.

The collection techniques are a killer. They often skirt the line and are scripted to do so. My sense is that in rural areas, which in Texas there is a lot of, they are overstepping but no one will call them on it in Federal Court because of the complexity of the process for too little return on an individual basis. Not to mention the fact that the debtors out there more likely than not will not know any better. They still think they can go to jail for not paying a debt... I wonder where they get that from??? The SEC is not going to pick up the plight of a single debtor. Money & volume help debt collectors in the collection of payday loans. I’ve heard some horror stories to be sure. Can’t wait to see them mess up while we have a Bankruptcy on file then volume will work to the debtors advantage.