Payday Loans and Consumer Financial Health / Federal Reserve Board

For a two-week $300 payday advance loan, payday lenders typically charge in excess of $45, a cost so high that many believe the loan could not possibly be in the best interest of the borrower. Nevertheless, some estimates indicate that payday loan volume grew more than fivefold to almost $50 billion from the late 1990s to the mid 2000s (Stegman 2007). With the recent rise of the payday lending industry, questions abound about the characteristics and circumstances of payday loan borrowers, and the ultimate impact of such loans on their welfare. Interest in payday lending has grown among economists in particular because of the possibility that transactions in this market may reflect a market failure due to asymmetric information or borrowers’ cognitive biases or limitations, or demonstrate divergence in behavior from traditional models (hyperbolic discounting, for example). In 2007, Congress and the Department of Defense moved to ban payday lending to members of the military based on the view that such lending traps service members in a cycle of debt and threatens military readiness.2 And in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act established the Consumer Financial Protection Bureau (CFPB) to help regulate the market for consumer financial products, including the payday loan market. Historically, regulation of payday lending to the general population has often come at the state level, but the CFPB has authority to write and enforce new federal regulations to the extent that they judge payday loans to be “unfair, deceptive or abusive,” and they have recently suggested that new consumer protections in the payday loan market may be forthcoming (CFPB 2013). In this paper, I draw on nationally representative panel data comprised of individual credit records, as well as Census data on the location of payday loan shops at the ZIP code level, to test whether payday loans affect consumers’ financial health. I use credit scores and score changes, as well as other credit record variables, as measures of financial health. Credit scores conveniently summarize one’s credit history, and previous research suggests payday loan usage could affect credit scores. Importantly, use of and performance on payday loans does not directly affect traditional credit scores (such as the FICO score). Rather, payday loans can affect scores indirectly to the extent that such loans either improve or undermine consumers’ ability to manage cash flow and meet their financial obligations in general.
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