Two weeks ago, I wrote about Hillbilly Elegy, J.D. Vance's account of his experiences growing up in a small Appalachian town. Towards the end of the book, the author makes a brief comment on payday lending which I want to expand on and explore in more detail today.
First, the context for his comment. After explaining why well-meaning lawmakers wish to tighten up regulations for these lenders, Vance shares a personal example demonstrating how he used a payday lender to cover unanticipated expenses (1). Broadly speaking, these lenders exist so those in the community are able to smooth out cash flow variations on short notice.
I liked his explanation. It highlighted a common problem when aggregated observations are broken into 'per-capita' metrics in the name of 'describing' individuals (a problem I've been thinking quite a bit about lately).
In this particular example, a policymaker probably looked at payday lending in the aggregate and saw the interest rates charged by payday lenders were many multiples higher than interest rates from nearby banks. I imagine the resulting conversation went something like this:
Scene: Three POLICYMAKERS are seated around a table.
Policymaker #1: Interest rates are almost 400%! What to do now?
Policymaker #2: Stand up for the little guy, obviously.
Policymaker #1: Yes! This is why we got into politics!
Policymaker #3: Maybe a little slice for us, too, while we are at it?
Policymaker #1: Sure, why not? We worked all morning!
Policymaker #2: Let's vote for a pay increase in the next house session.
(High fives are exchanged all around.)
(Exeunt POLICYMAKERS left.)
The problem here is not in the intent or even in the execution. The problem is just relying too much on math to excuse one-dimensional thinking. The aggregate metric was created by adding up the details of loan terms without considering the circumstances under which the loans were taken out. My hunch- let's call it my null hypothesis- is that people accept the best loan terms they can get. (Put another way, I don't hear too many stories about borrowers demanding higher interest rates from their banks.)
So, the policymaker might get more accomplished by questioning why the best possible loan at the time it was taken out was available at a payday lender rather than one of those banks it is being compared against. Jumping to regulate payday lenders without asking these questions will force some borrowers to the next lender on the chain. For some reason, I suspect this hypothetical 'next lender' will offer worse terms than the payday lender.
One thing I learned while researching payday lending for this little post was how payday lenders tend to serve specific demographics. In terms of annual income, a study by The Pew Charitable Trusts found those earning below $40,000 annually were one of five groups with greater odds of using a payday lender. However, I did not find many stories about payday lenders turning away people who earn more than $40,000.
My first crack at explaining these findings: borrowers above this $40,000 annual income threshold are finding better terms elsewhere. But let's put it more directly, shall we? (If anything, a blunter explanation will make for a more explosive blog post.) An alternate explanation is that banks are failing to serve lower income groups despite miraculously figuring out a way to serve higher income groups. (2)
Reading about payday lending reminded me of debates about health insurance. One way to lower health insurance premiums is to enroll healthier people in a plan. The thinking is healthier people tend to use fewer healthcare resources which means health insurance companies reimburse providers less for healthier members. But reverse the logic and...premiums can also go down if the least healthy people are removed from the plan! So if a health plan suddenly offers 'lower premiums', the savings came from either enrolling healthier members into the plan or by removing the sickest people from the insurance pool.
I see similarities to how banks might improve lending terms. If a bank serves only the most credit-worthy, the loans they offer will have lower interest rates. This attracts people with larger sums of money (let's call them the rich, or even The Rich) who have enough money to worry about things like the hundredths place. A bank seeking to attract these customers can lower interest rates in one of two ways: offer loans to more credit-worthy people or remove the least credit-worthy people from their books.
In a sense, a bank failing to service everyone who needs a loan ends up offering artificially low interest rates in the same way a health plan who refuses to enroll the unhealthy ends up offering artificially low premiums. Is this really a big deal? Well, I'm just old enough to remember who picked up the tab the last time the banks mucked this all up, so I say yes (3).
But despite some of my assured ranting above, I do not know all that much about payday lending. And I'm not here to ruin your Sunday. I'll leave it with a simple conclusion: the mere existence of payday lenders confirms for me the existence of a large enough group of borrowers who, for one reason or another, cannot borrow from banks at the very rates certain policymakers compare the payday lending rates to.
Footnotes / imagined complaints
0. Granted, this post script will ignore the impact of regulation, but who came here for my thoughts on regulation? Am I right?
It is possible banks refuse to lend to low income borrowers simply because lending to low income borrowers is bad for business. Research results suggest this is not the case, however, so I suspect the issue is more of banks systemically being unable to properly determine the risk of a loan.
Theoretically, a good bank will figure out the right interest rate for any borrower. So if a bank resorts to using a lazy proxy variable for determining credit worthiness, I start to worry about the bank's skill in evaluating a borrower's credit worth.
If this conclusion is on the right track, it is no wonder the banking system struggles to accurately price investments. It comes back to this payday lending question in a certain way. Instead of doing the hard work every hour to best serve all members of the community, banks devise ways to serve the customers who offer only the safest returns. A bank unable to figure out how to lend to everybody is as useful as a doctor who only sees perfectly healthy patients. When the time comes to truly understand a novel investment vehicle, banks fail not because of incompetence but due to a simple lack of practice.
Vance's example uses a short-term cash emergency to highlight how a charge from a payday lender often beats a bank's overdraft fee. Based on my own experience, I agree with him.
So, instead of paying the overdraft fee, the borrower goes to a payday lender. The terms are $100 today with a minimum of $15 due every two weeks until the loan is repaid. If the overdraft fee exceeds $15, this looks OK on paper.
But, what is the interest rate on the loan? Let's use the above example.
Is the interest rate:
a) 15%
b) 391%
c) 3733%
d) All of the above
e) Uhh.....
(The answer is basically irrelevant because it comes down to how the loan is repaid. I personally like 'd' though I recommend choosing 'e' if ever asked in person because people who pose such questions out of the blue are usually more interested in explaining the math than they are in hearing your answer, but anyway...)
Here is a breakdown of the various ways the interest rate on such a loan is reported:
1) 15%
$15 fee on $100 principal is a ratio of 15/100 = 0.15.
2) 391%
This assumes you carry the $100 loan for a year and pay $15 every 14 days: 0.15 x (365.25/14) = 3.91.
3) 3733%
This assumes you take out a new loan every 14 days that will cover your principal and "charge", and every new loan is taken at same 15% "charge" of the amount borrowed: (1 + 0.15)365.25/14 − 1 = 37.33.
I borrowed those calculations from footnote number six in this Wikipedia entry about payday loans.
2. Policy Spit-balling 101
Maybe a policymaker could penalize banks with a set proportion of account holders reporting income or assets above a certain threshold? Or, perhaps banks could be required to maintain a proportion of their customers at or below the $40,000 annual income level?
Or perhaps an individual mandate is needed requiring anyone borrowing at a payday lender to show proof of a checking or savings account at a bank?
Hmmm...
3. To answer with the extended analogy...
Let's just say healthy people are not forced to give up their spare kidneys anytime someone goes on dialysis.
