Since You Asked

Is payday lending really wrong?

“About half of US states have clamped down on payday loans by capping interest rates, or restricting them in ways that make them less profitable… Faced with a hostile home market, several US companies have hit upon the same solution: to set up shop in Britain.”

That doesn’t sound good.

Oh, I don’t know. Haven’t we been wringing our hands about a “credit crunch” for the past four years? At least somebody has stepped into the market. Payday lending is said by one analyst to be up from £100m in 2004 to £1.7bn in 2010. But that’s modest compared with over £55bn of outstanding credit card debt or more than £200bn of consumer credit – which includes everything from a credit card to paying in instalments for a new sofa. Bank lending is down sharply; consumer credit is up slightly after a big dip; only payday loans are showing strong growth.

You’re being facetious: payday loans are offered at extortionate rates.

I am being facetious – mostly. And yes, payday loans are at extortionate rates. Say you borrow £100 for a month and have to pay £125 at the end of the month. That’s an interest rate of 25 per cent a month, which compounds to about 1350 per cent a year.

This sort of thing is disgusting. Payday loans should just be banned.

Many people think that. An alternative is to cap the interest rate at something like 30 per cent, which would allow most store cards and credit cards but destroy the business model of payday loans. But aren’t we being a little bit hasty? This product tends to be discussed as though it’s something like heroin: profitable but corrosive. Isn’t it worth considering that payday loans are a valuable service, used by people in full control of their senses?

That’s ridiculous.

It’s not ridiculous at all. Consider the fuss that people now make about microcredit – small loans, often at interest rates well above 50 per cent a year that are said to help the very poorest families manage their finances and even become entrepreneurs. That’s a story that many people are happy to accept without examining the evidence, while at the same time condemning payday loans, which appear to be a similar product. Are you sure you’re not just reflecting a prejudice that credit-starved Bangladeshis are heroic would-be entrepreneurs while credit-starved westerners must be trailer trash?

Are you claiming that it is rational to take an interest rate of 1350 per cent?

Of course it could be, the question is whether it is rational in practice. Consider the founding story of microcredit – the moment in 1976 when Muhammad Yunus lent less than a dollar each to 42 rural craftswomen. Those women had previously made baskets and chairs, funded by a village moneylender at a rate of 10 per cent a day, which by my calculations is an annual rate of over 100,000 trillion per cent. I am not aware that anybody argues the women were irrational: until Mr Yunus came along they had no options but to take out the loan each morning to buy materials.

So what’s the evidence?

It’s mixed. For example, the economists Dean Karlan and Jonathan Zinman persuaded a South African consumer finance company providing loans for a few months at an interest rate of 200 per cent, to run an experiment randomising loan approvals for marginal applicants who would otherwise have been rejected. To Mr Karlan’s surprise, the borrowers who were randomly approved for loans did better than those who didn’t get the cash. The reason seems to be that those borrowers used the loans to pay essential bills – fixing a bike, buying clothes – that helped them keep their jobs. But another study by Mr Zinman and Scott Carrell, which paid a lot of attention to disentangling correlation and causation, found that in states where US Air Force personnel had access to payday loans, the combat-readiness of the Air Force suffered. There are reasons to be concerned about these loans, but we shouldn’t assume that they are never put to good use.

Why don’t banks enter this market? Surely competition would drive down rates.

The banks do compete in this market, albeit indirectly, by allowing people “unauthorised” overdrafts and charging them through the nose for them. The truth is that an unauthorised overdraft can be even more expensive than a payday loan. I am not sure that the banks would like to compete in this market more overtly: the current situation seems to suit them rather well.

Also published at ft.com.