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Why Do People Use Payday Loans?

posted by Paige Marta Skiba

Economic models of borrowing and saving offer a hat trick of (not necessarily mutually exclusive) explanations for why people would borrow on high-interest credit like payday loans: 1) Consumers may heavily discount the future, 2) Consumers may experience shocks that cause large, unanticipated variation in their immediate consumptions needs (such as car repair or emergency room visits), and 3) Consumers may have overly rosy forecasts (of either the shocks they will face or their own self-control).

Jeremy Tobacman and I recently put these three theories to real-world data on payday loan borrower behavior and found that behavior is consistent with people being at least partially naïve about their own self-control.

“Hyperbolic discounting” is the most widely used technique of modeling these self-control problems.  An important aspect of hyperbolic discounting is that there are multiple ways consumers can have self-control problems. One may be fully aware of her problem (“sophisticated”) or fully unaware (“naïve”) or somewhere in between.

What is an example of naïve hyperbolic discounting? Suppose a certain guest blogger had set her alarm for 5am every day for the last 8 years, planning to exercise before work—only to snooze until 7am every single day. This is very naïve behavior. She thinks she will have 100% willpower tomorrow, only to wake up every day and suffer the same old self-control issues.

How can we detect sophistication? We’d need to observe a commitment device—some evidence of restrictions on one’s own behavior. An example of a service that provides such devices is www.stickK.com.  stickK (started by who else but behavioral economists) allows you to “put a contract on yourself” to lose weight, manage debt, etc. Two weeks ago, I turned to stickK for help in battling the “assistant professor 15”—a potential corollary of snoozing through workouts. Each week, I log in to stickK and report my weight. If I don’t meet my goal, I am forced to send money via PayPal to my choice of an “anti-charity.” Enough anti-charity options are available to meet just about anyone’s political leanings. So far I am batting .500.

What are commitment devices in credit markets? With payday loans, Jeremy and I use behavior on defaults as potential evidence on sophistication. Because defaulting on a payday loan typically precludes future borrowing in the payday loan market, defaulting could be used by consumers who want to “tie their hands to the mast,” just like Ulysses. We find, however, that default behavior is most consistent with partial naïvete.

Conducting “welfare analysis” is our next step in “Payday Loans, Uncertainty and Discounting: Explaining Patterns of Borrowing, Repayment, and Default.” Based on real-world borrowing data, we will estimate whether consumers’ overall welfare would be higher in a world with payday loans or without.

In the meantime, let’s hope Charlton Heston doesn’t start sending me Thank You notes. 


In running our business, BankuptcyHome.com, and being involved with bankruptcy clients and cases, we've found that a lot of people in bankruptcy turned to payday loans when they felt they had no other options. Of course, the relative ease with which you can get some quick cash is pretty disturbing. Consumer really need to educate themselves as to what these outrageous businesses are all about, and this is ripping people off!

Too easy. I agree. It could be a useful tool for unexpected expenses, but all to often the ease of the tool hides pitfalls that are not easily seen. I see that its the least sophisticated of debtors that are more susceptible to default than more sophisticated debtors. Of course sophisticated debtors do not use such tools often or ever. This is not a tool for blue collar workers to budget money, its used to pay light or some other necessity. There are to be sure those who use it for party money but those who do are surely unsophisticated. No one in their right mind would use such a poor financial tool if they fully knew the implications. Kind of reminds me of the "Jackson Hewitt" deal where they were selling those investments loaded with fees with almost no return because it was such a poor financial tool. Who took the brunt of that one? Unsophisticated consumers.

Because traveling by handbasket on a road paved with good intentions just takes too darn long.

???? AMC, for Adam to say you make great points the comment above has to mean something.?? Can you elaborate a bit for someone who does not have the education you have? Just a little lost. It feels like a sarcastic remark but I can’t say for sure. Even if it is, you seem to be very knowledgeable and I would like to know what you think.

I agree with the three explanations for payday borrowing, but I would add a fourth, namely the habit of living paycheck-to-paycheck. This habit transcends the lower income class that makes up this data set. Many people well above the $20,000 annual income level are in the habit of living paycheck-to-paycheck. I would argue that this is different than the "overly rosy" outlook of the future in that it takes on a sense of "defeat" about future prospects without actually giving up. Some people come to accept their negative future prospects in the way that the mythological Sisyphus would roll the boulder up the hill only to begin over and over again.

Patches - it's just a snark based on two old cliched sayings: "going to hell in a handbasket" and "the road to hell is paved with good intentions". In my experience, payday loans get many borrowers to hell quicker. Sorry I was so obscure.

Your strategy requires forethought and planning, not necessarily the hallmark of knee-jerk and panicked borrowing.

Thanks AMC! No prob. I get it now. I Learn something new everyday on this site. Thanks for your posts..

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