Friday, July 16, 2010

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.


  1. All of this economic theorizing works just fine, until it runs into the reality of low IQ menial laborers, who, from time to time itch to go get properly drunk at a bar or the like.

    I am somewhat baffled that someone can claim, apparently with a straight face, that people risk going hungry in a country of food stamps and food banks for all who qualify. Do you honestly believe this yourself, Mr. Wenzel?

  2. @Anonymous#1 above:

    Please read "Economics in One Lesson" by Henry Hazlitt.

    Your logic is faulty when you cite the person of "low IQ" because they will pay the high rates regardless of whether or not there is a cap.

    When you assume the fatal conceit of believing you know what is best for other people, you seal your own fate because you accept the belief that some men have the right to tell others how to live.

    Please do your self (and the rest of us) a favor and read Mr. Hazlitt's book - it's available for free here:

    Incidentally, food stamps/banks are typically funded by stolen (via taxation) money - in case you didn't know...

  3. Sorry a person who purports to value freedom,

    YOUR logic is faulty, and horribly so.

    First of all, as long as you VOLUNTARILY live in the United States, that is unless PHYSICALLY prevented from leaving the United States, you pay your takes of your own assent, and any talk of the taxes being "stolen" is utter nonsense.

    Your second claim is also nonsense. I harbor no fatal conceit that "some have the right to tell others how to live;" what I believe, and what has been the case since our existence as cave men, is that when humans live together, they have agreed to the parameters of their co-existence or left their group.

    Ever since 1776, real Americans have used the electoral process to determine who these rules were to be made (a few stolen elections notwithstanding.) I don't believe they get everything right, but I believe that someone has to make the rules, and that if I don't like the rules, I should either get involved inthe political system, or move somewhere else.

    If you reject the Americna tradition, may I urge you to move to a more congenial political system?

    As for paycheck loans, many of them are impulse decisions by low IQ people. Banning them won't make the disappear, but will make them rarer, and harder to enforce.

    The fact of the matter is that America has a fair number of functional illiterates on the bad side of the bell curve who can barely take care of themselves, even if one of them was recently president. The snotty bastards are not those who talk about this fact, but those who couldn't care less.

  4. In response to Anonymous above:

    You wrote:

    "Your second claim is also nonsense. I harbor no fatal conceit that "some have the right to tell others how to live;" what I believe, and what has been the case since our existence as cave men, is that when humans live together, they have agreed to the parameters of their co-existence or left their group."

    To which I respond: Essentially, what you are saying is that if the gang of the majority decide to take your life, liberty, or property then you have to move if you don't agree with their vote.

    You also wrote:

    "If you reject the American tradition, may I urge you to move to a more congenial political system?"

    To which I respond: This is a continuation of your argument and it fails because you are essentially saying "It is okay to kill, enslave, and plunder and, if you don't like it, you are welcomed to leave."

    Just because someone makes - in your opinion - a poor decision, you feel to you have the right to override their free will and make the decision for them. This is spoken like a true Socialist - one who has good intentions but whose actions result in evil perversions.

  5. Oh how the slaves love their chains and condemn anyone who wants to be free.

  6. In response to those comments above. I have just taken out a payday loan myself. There is nothing wrong with my IQ and I am willing to match any of you socialists on personal economist. I took out this PayDay loan because I found a very nice used car that was thousands of dollars below market. The $213 I had to pay for a 30 day loan of $1,000 has saved me nearly $3,000 and without this loan I would have been unable to get this car. This month will be tight because I will have to repay the loan but I feel I have made a great deal. Please don't try to protect me and others for something you have perceived as protecting me from my self. Was the loan a bad loan YES at 275% APR it surly was but did I make a great deal out of it YES I did. Let this Nation remain FREE. You are not smarter or more intelligent than all those people that may for what ever reason need a Payday Loan a few times in there lives. I was damn glad to get it.