The Economics of "Predatory Lending"

Arizona has just put a cap on rates finance firms can charge on loans. As far as I am concerned, it's the full employment act for loan sharks. The loans will still be made, except they will be made in back alleys. The rates will be just as high, if not higher. The real difference is there will no longer be personal bankruptcy relief. Instead, you will pay or the pain will starts, first a broken arm, then other important parties of your body.

Steven Horowitz explains the economics of "predatory lending" here and why the rates are so high:

According to CNN, Arizona has now become the 17th state to ban payday lenders by capping their effective annual interest rate at 36 percent. Payday lenders specialize in short-term loans, usually two weeks to a month, at high annual interest rates, often to borrowers who can find no other source of credit. These lenders provide liquidity to borrowers to carry them over until payday, when the loans are repaid. CNN reports that an interest charge of $17 per $100 borrowed on a 14-day loan is typical. This comes out to about a 400 percent interest rate if the loan is carried a full year. The usual suspects see these practices as “predatory” and “abusive.”

But who exactly is hurt here? No one points a gun at the heads of the borrowers. Clearly they perceive a need for that additional liquidity and, to use a little economic jargon, their time preference is high enough that they are willing to pay the high rate for the very short-term loan. Their willingness to do so is most likely a consequence of their poverty; they lack the assets and collateral, and even the human capital, necessary to get a standard loan or a credit card. For such people the payday loan option is better than going hungry between paychecks.

High Default Rate

Obviously, high interest rates make payday lending look like a big bucket of profits for the lenders, but CNN also reports that the default rate within the first 12 months is about 50 percent. The reporter makes this seem like evidence for the abusiveness of the practice: Somehow lenders are forcing loans on bad credit risks. But the reality is that these are bad credit risks, which is why they are using this type of lender and why the interest rate is so high! As one of the lenders comments, they can’t make money at 36 percent with a 50 percent default rate.

Credit card companies’ default rates are in the high single digits — high enough that they need to compensate for the risk of unsecured loans by charging 18 percent or more. Even now, mortgage default rates are half that of credit card rates, and since mortgage loans have assets backing them, lenders don’t need to charge high rates to compensate for the default risk. With a default rate of 50 percent, it is understandable that payday lenders would want to charge very high interest rates.

A 36 percent cap, which is nothing more than a standard price control, will have the usual effects. It will limit the quantity of credit supplied and increase the quantity demanded, producing a credit shortage. In fact, the payday lenders have left states that have enacted such laws, creating the shortage.