Monday, July 11, 2005
The end of anonymity
Thinking about the London subway bombings last week, it seems like one thing is certain. In just a few years, after one or two more incidents like this, we are very likely to see the end of anonymity in human society.
What happened on Thursday is that several people walked with complete anonymity into several subway stations. They planted their bombs invisibly and then either left the scene or remained to be detonated. We have no idea who they were, where they came from, who they associated with or where they went if they left the scene.
We consider anonymity like this to be completely normal today. And we see the effects of this anonymity constantly, simply by reading the paper or watching the news. Anonymity gives criminals a huge advantage. The O.J. Simpson case and its "trial of the century" brought this point home with a big splash 10 years ago. On June 12, 1994, two people died in a brutal murder and no one can conclusively prove who did it. We have no idea who was on the street near Nicole Brown Simpson and Ronald Goldman at the time of the murder, or where O.J. Simpson was that night.
The O.J. case is one end of the spectrum – a gigantic murder mystery. At the other end are tiny crimes that happen anonymously everyday. For example, one of my neighbors found the envelope of a credit card bill torn open and lying on the grass near his mailbox last week. He has no idea who did it, and therefore had to cancel all of his credit cards that afternoon.
It would be relatively easy to eliminate anonymity today, and that is why its end is near. All that we need is a way to read biometric information (thumbprint, iris, whatever) whenever a person enters and leaves an area like a subway station. This might be done very simply with thumbprint-reading turnstiles. This type of identity gathering will occur at the entrance to every subway station, building, airport, mall, campus, park, stadium, etc. In addition, the identity of every car will be tracked as it moves around.
That will be the first level of the net. With these simple measures, we would know the identity of everyone who entered the subway stations on Thursday. That data would make it easy to discover the identity of the London terrorists in just a few days.
Then the net will tighten. Once it is known who is entering each facility, it will be possible to use cameras to track each person's motion and identify their exact location on a moment by moment basis. If Person X stops to talk to Person Y, that will be known. So will all of Person X's and Person Y's phone calls, email messages, package deliveries, purchases, etc. No longer will email messages and spam arrive with anonymity – we will know exactly who sent them, and so will "the authorities". That means that once the criminals are caught, all of their associates will be caught as well. Entire terrorist cells will be rooted out quite easily once anonymity disappears.
Is this good or bad? It doesn't really matter – it is inevitable. Anonymity is simply an artifact of our non-technological past. The only reason we have anonymity today is because, in the past, it would have been too expensive and too onerous to eliminate it. Today we can use technology to eliminate anonymity at low cost and with only small inconvenience. We will gladly deploy the technology to eliminate everything from petty theft to global terrorism. Given a choice between "anonymity" and "the potential to have a city blown up by terrorists", we will choose to lose our anonymity.
Once anonymity is gone, it is very likely that we will eliminate crime as we know it today. That will be a very good thing. According to this page, in the year 2000 in the United States there were:
What happened on Thursday is that several people walked with complete anonymity into several subway stations. They planted their bombs invisibly and then either left the scene or remained to be detonated. We have no idea who they were, where they came from, who they associated with or where they went if they left the scene.
We consider anonymity like this to be completely normal today. And we see the effects of this anonymity constantly, simply by reading the paper or watching the news. Anonymity gives criminals a huge advantage. The O.J. Simpson case and its "trial of the century" brought this point home with a big splash 10 years ago. On June 12, 1994, two people died in a brutal murder and no one can conclusively prove who did it. We have no idea who was on the street near Nicole Brown Simpson and Ronald Goldman at the time of the murder, or where O.J. Simpson was that night.
The O.J. case is one end of the spectrum – a gigantic murder mystery. At the other end are tiny crimes that happen anonymously everyday. For example, one of my neighbors found the envelope of a credit card bill torn open and lying on the grass near his mailbox last week. He has no idea who did it, and therefore had to cancel all of his credit cards that afternoon.
It would be relatively easy to eliminate anonymity today, and that is why its end is near. All that we need is a way to read biometric information (thumbprint, iris, whatever) whenever a person enters and leaves an area like a subway station. This might be done very simply with thumbprint-reading turnstiles. This type of identity gathering will occur at the entrance to every subway station, building, airport, mall, campus, park, stadium, etc. In addition, the identity of every car will be tracked as it moves around.
That will be the first level of the net. With these simple measures, we would know the identity of everyone who entered the subway stations on Thursday. That data would make it easy to discover the identity of the London terrorists in just a few days.
Then the net will tighten. Once it is known who is entering each facility, it will be possible to use cameras to track each person's motion and identify their exact location on a moment by moment basis. If Person X stops to talk to Person Y, that will be known. So will all of Person X's and Person Y's phone calls, email messages, package deliveries, purchases, etc. No longer will email messages and spam arrive with anonymity – we will know exactly who sent them, and so will "the authorities". That means that once the criminals are caught, all of their associates will be caught as well. Entire terrorist cells will be rooted out quite easily once anonymity disappears.
Is this good or bad? It doesn't really matter – it is inevitable. Anonymity is simply an artifact of our non-technological past. The only reason we have anonymity today is because, in the past, it would have been too expensive and too onerous to eliminate it. Today we can use technology to eliminate anonymity at low cost and with only small inconvenience. We will gladly deploy the technology to eliminate everything from petty theft to global terrorism. Given a choice between "anonymity" and "the potential to have a city blown up by terrorists", we will choose to lose our anonymity.
Once anonymity is gone, it is very likely that we will eliminate crime as we know it today. That will be a very good thing. According to this page, in the year 2000 in the United States there were:
- 1.4 million violent crimes
- 10.2 million property crimes
- 15,000 murders
- 90,000 forcible rapes
- 407,000 robberies
- 1.1 million vehicle thefts
- And so on...
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Except that smallpox was a far worse horror than all crime and war combined, I basically agree. It might take more like 30 years than 20. 15 for early adopter cities.
By the way, if you don't know, there is a very popular book on this topic by David Brin. It's called "the transparent society".
By the way, if you don't know, there is a very popular book on this topic by David Brin. It's called "the transparent society".
# posted by 
: 10:01 AM
: 10:01 AM
Anonymity is a fairly recently development. In the past people lived in small communities where eveyone knew and relied on each other. You could choose anonymity be going somewhere no one knew you, but you would most likely be shunned and possibly harmed.
# posted by : 12:40 PM
: 12:40 PM
If the lack of anonymity makes people feel more secure, it could actually lead to an increase in crime if it gives the criminals easier targets.
Crime is just an economic issue. Raise the costs high enough and criminals will quit. The question is will the massive govt dB actually work well enough to raise the cost.
My bet is no. Evil has existed since the beginning of time. 4 billion cameras and fingerprint scanners tied to a cluster of Oracle dB's won't change that.
Crime is just an economic issue. Raise the costs high enough and criminals will quit. The question is will the massive govt dB actually work well enough to raise the cost.
My bet is no. Evil has existed since the beginning of time. 4 billion cameras and fingerprint scanners tied to a cluster of Oracle dB's won't change that.
I agree. The only people who want to remain anonymous are those with something to hide. If you don't want other people to know you're doing something, you probably shouldn't be doing it. I'd gladly live in a society without anonymity.
The problem with a system which can backtrack any criminal to find the associates is that it can do the same with anyone else, for any reason.
Backtrack all the political activists you don't like to find their associates, and harass them.
Or the adherents of some particular religion.
Or the people who visit "clothing optional" resorts.
Any system like this is tailor-made for totalitarianism. Anonymity and privacy are required for freedom.
Backtrack all the political activists you don't like to find their associates, and harass them.
Or the adherents of some particular religion.
Or the people who visit "clothing optional" resorts.
Any system like this is tailor-made for totalitarianism. Anonymity and privacy are required for freedom.
"I can't see how any of the examples you cite would limit freedom."
If every second of one's life can be scrutinized by anyone who cares to, the people who are most likely to do so are the ones with the most narrow concept of what is decent and proper. Even if the government doesn't care (and if John Ashcroft can be approved for the office of Attorney General, you can be sure that there are busybodies at the highest level), people like that can make your life very difficult. This is one of the reasons people leave small towns.
I can see the combination of no anonymity or privacy combined with busybodies resulting in greatly increased murder and suicide rates; if people cannot shut others out of their lives, there are only two other things that can give.
If every second of one's life can be scrutinized by anyone who cares to, the people who are most likely to do so are the ones with the most narrow concept of what is decent and proper. Even if the government doesn't care (and if John Ashcroft can be approved for the office of Attorney General, you can be sure that there are busybodies at the highest level), people like that can make your life very difficult. This is one of the reasons people leave small towns.
I can see the combination of no anonymity or privacy combined with busybodies resulting in greatly increased murder and suicide rates; if people cannot shut others out of their lives, there are only two other things that can give.
So, what happened to the Gattaca reference? I know it was wrong (blood sample, not fingerprints), but wouldn't strikeout with corrections, or a post script UPDATE: be preferable to disappearing it?
# posted by : 11:24 AM
: 11:24 AM
Here's the response from my blog:
For a vivid dystopian imagining of this technology, "Minority Report" is hard to beat. Identified by long-range retina scans, people are followed -- everywhere -- by the equivalent of personalized multimedia junkmail. Not an improvement. More classically, telescreens from 1984 made things very "secure".
I agree that anonymity as we know it is changing, and trying to preserve the status quo indefinitely is futile. However, that does not mean we should be apathetic about it. Vitally important questions remain around how this information will be managed, what it can be used for, who will have access, how abuse will be punished, and what people's rights are when it comes to their own information.
For a vivid dystopian imagining of this technology, "Minority Report" is hard to beat. Identified by long-range retina scans, people are followed -- everywhere -- by the equivalent of personalized multimedia junkmail. Not an improvement. More classically, telescreens from 1984 made things very "secure".
I agree that anonymity as we know it is changing, and trying to preserve the status quo indefinitely is futile. However, that does not mean we should be apathetic about it. Vitally important questions remain around how this information will be managed, what it can be used for, who will have access, how abuse will be punished, and what people's rights are when it comes to their own information.
# posted by : 11:28 AM
: 11:28 AM
Dont worry, Big Brother will take care of you. History has proven that the governments that have more control over their people and large amounts of information about everyones affairs usually take better care of their populations.
Another flaw in your analysis, in relation to the london bombings or the 911 bombings: the information would enable us to know who just murder all those people, it would do nothing to stop the murder. The complete and total loss of liberty may reduce petty crimes, but suicide bombers, rapists, and murderers very often arent too worried about getting caught when they perpatrate their acts.
If given the choice between turning my life over to big brother or having to cancel my credit cards, I'll just cancel my credit cards. The government can protect my property and enforce my contracts with complete disregaurd to my identity. Given the choice between living in a free society and having thousands of people die or living in a controlled society, I'd rather watch citizens die.
Furthermore, nothing should be made illegal simply because it has the potential to be abused. You'll bitch when you lose your freedom of speach in this blog, but you will lose it because it has the potential to be abused. The same goes for MP3 players, DVD burners, fast cars, weapons, and a hundred other things. I refuse to support laws that are addressed to the lowest eliments of society and I refuse to give up my freedoms because other peoplpe have abused them.
"People willing to trade their freedom for temporary security deserve neither and will lose both."
- B. Franklin
ps. Proud to post anonymously from behind multiple firewalls, with encryption, and under a spoofed IP.
Another flaw in your analysis, in relation to the london bombings or the 911 bombings: the information would enable us to know who just murder all those people, it would do nothing to stop the murder. The complete and total loss of liberty may reduce petty crimes, but suicide bombers, rapists, and murderers very often arent too worried about getting caught when they perpatrate their acts.
If given the choice between turning my life over to big brother or having to cancel my credit cards, I'll just cancel my credit cards. The government can protect my property and enforce my contracts with complete disregaurd to my identity. Given the choice between living in a free society and having thousands of people die or living in a controlled society, I'd rather watch citizens die.
Furthermore, nothing should be made illegal simply because it has the potential to be abused. You'll bitch when you lose your freedom of speach in this blog, but you will lose it because it has the potential to be abused. The same goes for MP3 players, DVD burners, fast cars, weapons, and a hundred other things. I refuse to support laws that are addressed to the lowest eliments of society and I refuse to give up my freedoms because other peoplpe have abused them.
"People willing to trade their freedom for temporary security deserve neither and will lose both."
- B. Franklin
ps. Proud to post anonymously from behind multiple firewalls, with encryption, and under a spoofed IP.
# posted by : 2:35 PM
: 2:35 PM
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# posted by : 5:30 AM
: 5:30 AM
A payday loan is a short-term loan that you promise to pay back from your next pay cheque. A payday loan is sometimes also called a payday advance.
Normally, you have to pay back a payday loan on or before your next payday (usually in two weeks or less). The amount you can borrow is usually limited to 30 percent of the net amount of your pay cheque. The net amount of your pay cheque is your total pay, after any deductions such as income taxes. For example, if your pay cheque is $1,000 net every two weeks, your payday loan could be for a maximum of $300 ($1,000 x 30%).
Before giving you a payday loan, lenders will ask for proof that you have a regular income, a permanent address and an active bank account. Some payday lenders also require that you be over the age of 18.
To make sure you pay back the loan, all payday lenders will ask you to provide a postdated cheque or to authorize a direct withdrawal from your bank account for the amount of the loan, plus all the different fees and interest charges that will be added to the original amount of the loan. The combination of multiple fees and interest charges are what make payday loans so expensive (Click here for an explanation of the various fees associated with these types of loans.
The lender should also ask you to sign a loan agreement. If the lender does not offer to give you a copy of the loan agreement, ask for one. Read this document carefully before signing it, and keep a copy for your records
How and when do I pay back the loan?
A payday loan agreement usually says that you must pay the total amount you owe for the loan on or before the date stated in your loan agreement. This includes the amount you borrowed, plus interest and any additional fees and charges.
Some lenders will cash your postdated cheque or process your direct withdrawal on the day the loan is due. However, some lenders may require that you pay the loan in cash, on or before the due date.
If you have not paid the loan in cash by the due date, some lenders may cash your cheque or process the direct withdrawal you signed on the day after your loan's due date, and charge you another fee. Ask the lender what the most inexpensive way is for you to repay your loan.
How does a payday loan affect my credit report?
Credit-reporting agencies collect information on whether or not you make your payments on time. This information, also called your "credit history", is part of your credit report and is used to calculate your credit score.
Making payments on time can help improve your credit score by demonstrating that you are able to manage your debt. Even if you have poor credit, you can rebuild it by using a credit card or other type of credit and paying back the money you owe on time.
This is not the case with payday loans. Since payday lenders are not currently members of the main credit-reporting agencies, getting a payday loan and paying it off on time will not improve your credit score. However, if you do not pay your loan back on time and it is sent to a collection agency, this will likely be reported to a credit-reporting agency and could have a negative impact on your credit report.
How much will a payday loan cost?
A payday loan is much more expensive than most other types of loans offered by financial institutions such as banks or credit unions. Before you apply for a payday loan, find out about all the fees and charges you will have to pay — including the fees you will be charged if you cannot repay the loan on time. The fees may not be easy to see right away, so read the agreement carefully before signing it. If you do not receive an explanation of all of the fees, charges and interest that will apply to the loan, or if you are not satisfied with the explanation you receive, do not sign the loan agreement.
How does the cost of a payday loan compare with other credit products?
Payday loans are much more expensive than other types of loans, including credit cards. But how much are you really paying? How does the cost of a payday loan compare with taking a cash advance on a credit card, using overdraft protection on your bank account or borrowing on a line of credit?
Let's compare the cost of using different types of loans. We'll assume that you borrow $300, for 14 days. Note the considerable difference in the cost of each type of loan.
Things to consider before you apply for a payday loan
Even if you think you may be turned down, ask your bank or credit union for overdraft protection on your bank account, or a line of credit. These are relatively inexpensive ways of obtaining access to extra funds, for short-term use.
If you are turned down for any of these credit options, ask why. If the reason is that you have a poor credit history, contact the three credit-reporting agencies to get a copy of your credit report. Read the reports carefully to make sure that all of the information in it is correct. If you find any errors, contact the credit-reporting agency to find out how you can have the information corrected. The three major credit-reporting agencies in Canada are Equifax Canada, TransUnion Canada and Northern Credit Bureaus. All three of these agencies will give you a copy of your credit report for free if you request that it be sent to you by regular mail.
Ask yourself if you really need to take out a loan, or whether you can get by until your next pay cheque. If you need the money immediately, try to make other arrangements. For example, you may be able to cash in vacation days. Or you might consider getting a short-term loan from a family member or a friend.
If you find that you need to apply for a payday loan because you have no alternative, only borrow an amount that you are 100 percent sure you can repay on the due date of the loan.
Don't borrow more than you need.
Things to consider if you take out a payday loan
Don't be afraid to ask a lot of questions. Read carefully — and take home with you — a copy of the loan agreement that you are being asked to sign. Don't feel pressured to sign the loan agreement right away if you have questions and want more time to read through the agreement on your own. If the lender does not want to give you a copy of the agreement, look for another lender.
Be sure to ask about all the fees, charges and interest that apply when you first get the loan, and what other charges you will owe if you can't pay the loan back on time.
If you are taking out a payday loan at another location to pay back the first payday loan, or you are extending or "rolling over" the loan that you had with the same lender, you could find yourself in serious financial difficulty. The fees, charges and interest will add up quickly on these types of loans, which can put you into serious debt.
How can I figure out the cost of each type of loan?
To estimate the total cost of a loan, including the annual cost of the loan expressed as a percentage of the amount borrowed, follow the steps below.
Step 1:
Determine how much interest you will pay. First, find out the annual interest rate that applies to the loan (if there is one). Figure out the daily interest rate by dividing the annual interest rate of the loan by 365 days. Then, multiply that rate by the length of time you are taking the loan. Finally, multiply the result by the amount you will borrow, in dollars:
Amount of interest
= Annual interest rate
--------------------------------------------------------------------------------
365 days × Length of the loan
(number of days) × Amount of the loan
Step 2:
Determine the total cost of the loan by adding any fees that may apply to the interest you will have to pay. Find out what fees apply to the loan and add them to the cost of the interest, found in Step 1:
Total cost of the loan = Amount of interest + Total fees
Step 3:
Estimate the annual cost of the loan, expressed as a percentage of the amount borrowed. First, divide the total cost of the loan, found in Step 2, by the amount of the loan. Then, divide this rate by the length of time you are taking the loan (in days) and multiply it by 365 (the number of days in the year):
Annual cost of the loan (%)
= Cost of the loan
--------------------------------------------------------------------------------
Amount of the loan ÷ Length of the loan
(number of days) × 365 days
Let's find out the cost of a $300 payday loan, taken for 14 days.
We'll assume that the lender charges you a one-time set-up fee of $10 and a service fee of $40, which includes interest on the loan.
Step 1:
Determine how much interest you will pay. In this case, there is no interest fee. The interest is therefore $0.
Step 2:
Figure out the cost of the loan by adding together any fees that apply and the interest you will have to pay. In this case, you would add the $10 set-up fee and the $40 service fee together:
$10 + $40 = $50
Step 3:
Estimate the total annual cost of the loan, expressed as a percentage of the amount borrowed:
Annual cost of the loan (%)
= Cost of the loan
--------------------------------------------------------------------------------
Amount of the loan ÷ Length of the loan
(number of days) × 365 days
= $50
———— ÷ 14 days × 365 days
$300
= 4.35 or approximately 435%
The total cost of the payday loan would be $50 with an annual cost of 435 percent of the amount borrowed.
Information asymmetries are common in credit market models, but the usual assumption,
at least in commercial lending, is that borrowers are the better informed party and that
lenders have to screen and monitor to assess whether firms are creditworthy. The opposite
asymmetry, as we assume here, does not seem implausible in the context of consumer lending.
“Fringe” borrowers are less educated than mainstream borrowers (Caskey 2003), and many
are first-time borrowers (or are rebounding from a failed first foray into credit). Lenders
know from experience with large numbers of borrowers, whereas the borrower may only have
their own experience to guide them. Credit can also be confusing; after marriage, mortgages
are probably the most complicated contract most people ever enter. Given the subtleties
involved with credit, and the supposed lack of sophistication of sub-prime borrowers, our
assumption that lenders know better seems plausible.
While lenders might deceive households about several variables that influence household
loan demand, we focus on income. We suppose that lenders exaggerate household’s future
income in order boost loan demand. Our borrowers are gullible, in the sense that they can
be fooled about their future income, but they borrow rationally given their beliefs. Fooling
borrowers is costly to lenders, where the costs could represent conscience, technological costs
(of learning the pitch), or risk of prosecution. The upside to exaggerating borrowers’ income
prospects is obvious—they borrow more. As long as the extra borrowing does not increase
default risk too much, and as long as deceiving borrowers is easy enough, income deception
and predatory—welfare reducing—lending may occur.
After defining predatory lending, we test whether payday lending fits our definition. Payday
lenders make small, short-term loans to mostly lower-middle income households. The
business is booming, but critics condemn payday lending, especially the high fees and frequent
loan rollovers, as predatory. Many states prohibit payday loans outright, or indirectly,
via usury limits.
To test whether payday lending qualifies as predatory, we compared debt and delinquency
rates for households in states that allow payday lending to those in states that do not. We
focus especially on differences across states households that, according to our model, seem
more vulnerable to predation: households with more income uncertainly or less education.
We use smoking as a third, more ambiguous, proxy for households with high, or perhaps
hyperbolic, discount rates. In general, high discounters will pay higher future costs for a
given, immediate, gain in welfare. Smokers’ seem to fit that description. What makes the
smoking proxy ambiguous is that smokers may have hyperbolic, not just high, discount rates.
Hyperbolic discount rates decline over time in a way that leads to procrastination and selfcontrol
problems (Laibson 1997). The hyperbolic discounter postpones quitting smoking,
or repaying credit. Without knowing whether smokers discount rates are merely high, or
hyperbolic, we will not be able to say whether any extra debt for smokers in payday states
is welfare reducing.2
Given those proxies, we use a difference-in-difference approach to test whether payday
lending fits our definition of predatory. First we look for differences in household debt
and delinquency across payday states and non-payday states, then we test whether those
difference are higher for potential prey. To ensure that any such differences are not merely
state effects, we difference a third time across time by comparing whether those differences
changed after the advent of payday lending circa 1995. That triple difference identifies any
difference in debt and delinquency for potential prey in payday states after payday lending
was introduced.
Our findings seem mostly inconsistent with the hypothesis that payday lenders prey on,
i.e., lower the welfare of, households with uncertain income or households with less education.
Those types of households who happen to live in states that allow unlimited payday loans
are less likely to report being turned down for credit, but are not more likely, by and large,
to report higher debt levels, contrary to the overborrowing prediction of our model. Nor are
such households more likely to have missed a debt payment in the previous year. On the
contrary, households with uncertain income who live in states with unlimited payday loans
are less likely to have missed a debt payment over the previous year. The latter result is
consistent with claims by defenders of payday lending that some households borrow from
2Consistent with a high discount rate, Munasinghe and Sicherman (2000) discover that smokers have
flatter wage profiles and they are willing to trade more future earnings for a given increase in current earnings.
Gruber and Mulainathan (2002) find that high cigarette taxes make smokers ”happier,” consistent with
hypberbolic discount rates (because taxes help smokers commit to quitting). DellaVigna and Malmendier
(2004) show how credit card lenders can manipulate hyperbolic discounters by front-loading benefits and
back-loading costs.
payday lenders to avoid missing payments on other debt. On the whole, our results seem
consistent with the hypothesis that payday lending represents a legitimate increase in the
supply of credit, not a contrived increase in credit demand.
We find some interesting differences for smokers, but those differences are harder to
interpret in relation to the predatory hypothesis without knowing apriori whether smokers
are hyperbolic, or merely high, discounters.
We also find, using a small set of data from different sources, that payday loan rates
and fees decline significantly as the number of payday lenders and pawnshops increase.
Reformers often advocate usury limits to lower payday loan fees but our evidence suggests
that competition among payday lenders (and pawnshops) works to lower payday loan prices.
Our paper has several cousins in the academic literature. Ausubel (1991) argues that
credit card lenders exploit their superior information about household credit demand in their
marketing and pricing of credit cards. The predators in our model profit from their information
advantage as well. Our concept of income delusion or deception also has a behavioral
flavor, as well, hence our use of smoking as a proxy for self-control problems. Brunnermeier
and Parker (2004), for example, imagine that households choose what to expect about future
income (or other outcomes). High hopes give households’ current “felicity,” even if it
distorts borrowing and other income-dependent decisions. Our households have high hopes
for income, and they make bad borrowing decisions, but we do not count the current felicity
from high hopes as an offset to the welfare loss from overborrowing.
Our costly falsification (of household income prospects) and costly verification (by counselors)
resemble Townsend’s (1979) costly state verification and Lacker andWeinbergs’ (1989)
costly state falsification. The main difference here is that the falsifying and verifying comes
before income is realized, not after.
More importantly, we hope our findings inform the current, very real-world debate,
around predatory lending. The stakes in that debate are high: millions of lower income
households borrow regularly from thousands of payday loan offices around the country. If
payday lenders raise household welfare by relaxing credit constraints, anti-predatory legislation
may lower it.
Payday lenders make small, short-term loans to households. The typical loan is about $300
for two weeks. The typical fee is $15 per $100 borrowed. Lenders require two recent pay
stubs (as proof of employment), and a recent bank account statement. Borrowers secure
the loan with a post-dated personal check for the loan amount plus fees. When the loan
matures, lenders deposit the check.
Payday lending evolved from check cashing much like bank lending evolved from deposit
taking. For a fee, check cashiers turn personal paychecks into cash. After cashing several
paychecks for the same customer, lending against f uture paychecks was a natural next step.
High finance charges is the main criticism against payday lenders. The typical fee of $15
per $100 per two weeks implies an annual interest rate of 15x365/14, or 390 percent. Payday
lenders are also criticize for overlending, in the sense that borrowers often refinance their
loans repeatedly, and for ”targeting” women making the transition from welfare-to-work
(Fox and Mierzewski 2001) and soldiers (Graves and Peterson 2004).
Despite their critics, payday lending has boomed. The number of payday advance offices
grew from 0 in 1990 to 14, 000 in 2003 (Stegman and Harris 2003). The industry originated
$8 to $14 billion in loans in 2000, implying 26-47 million individual loans. Rapid entry
suggests the industry is profitable.
Payday lenders present stiff competition for pawnshops, even though the internet, namely
E-bay, significantly foreclosure costs for pawnshops (Caskey 2003). The number of pawn
shops in the U.S. grew about six percent per year between 1986 and 1996, but growth
essentially stalled from 1997 to 2003. Prices of shares in EZCorp, the largest, publicly
traded pawn shop holder, were essentially flat or declining between 1994 and 2004, while
Ace Cash Express share prices, a retail financial firm selling check cashing and payday loans,
rose substantially over that period (Figure 4). EZCorp CEO, Joseph Rotunday, blamed
payday lenders for pawnshops’ dismal performance:
The company had been progressing very nicely until the late 1990s.... (when)
a new product called payroll advance/payday loans came along and provided our
customer base an alternative choice. Many of them elected the payday loan over
the traditional pawn loan. (Quoted by Caskey (2003) p.14).
Payday lending is heavily regulated (Table 1). As of 2001, eighteen states effectively
prohibited payday loans via usury limits, and most other states prices, loan size, and loan
frequency per customer (Fox and Mierzwinski 2001). Note that the payday loan limit ranges
from 0 (where payday loans are illegal) to 1250. Nine states allow unlimited payday loans.
Payday lenders have circumvented usury limits by affiliating with national or state
chartered banks, but the Comptroller of the Currency—the overseer of nationally chartered
banks–recently banned such affiliations. The Federal Deposit Insurance Corporation still
permits payday lenders to affiliate with state banks, but recently restricted those partnerships
(Graves and Peterson 2005).
Regulatory risk—the threat of costly or disabling legislation in the future—looms large for
Payday lenders. The Utah legislature is reconsidering its permissive laws governing payday
lending. North Carolina recently drove payday lenders from the state by expressly outlawing
the practice.
Heavy regulation increases the cost of payday lending. High regulatory risk increases limits
entry into the industry and increases the expected return required by industry investors.
Driving up costs and driving away investors may be exactly what regulators intended if they
view payday lending as predatory.
We define predatory lending as a welfare reducing provision of credit. Households can be
made worse off by borrowing if lenders can deceive households into borrowing more than is
optimal. Excess borrowing reduces household welfare, and may increase default risk.
We illustrate our concept of predatory lending in a standard model of household borrowing.
Before we get to predatory lending, we review basic principles about welfare improving
lending, the type that lets households maintain their consumption despite fluctuations in
their income.
The model has two periods: today (period zero) and payday (period one. Household income
goes up and down periodically, but not randomly (for now): income equals zero today
and y on payday. If households consume Ct in period t, their utility is U (Ct).Household welfare
is the sum of utility over both periods: U (C0)+δU (C1), where δ equals the household’s
time rate of discount. Households with high δ value current consumption highly relative to
future consumption. In other words, high discounters are impatient.
A digression here on discount rates serves later discussion. In classical economics δ is
constant. If δ changes over time, so does household behavior, even if nothing else changes.
If δ(t) is hyperbolic, households will postpone unpleasant tasks until current consumption
does not seem so precious relative to future consumption (Laibson 1997). With hyperbolic
discounting, that day never arrives, so hyperbolic discounters have behavioral problems: they
procrastinate. They may never repay debt, much less begin saving. Hyperbolic discounters
who start smoking may never quit.
Returning to the model, if the marginal utility of consumption (U 0) is diminishing, households
will demand credit to reduce fluctuations in their standard of living. Households
without credit, however, must fend for themselves (autarky). Welfare under autarky equals
U(0)+δU (y). The fluctuations in consumption for households without credit make autarky
a possible worst case, and hence, a good benchmark for comparing cases with credit.
If households borrow B at interest rate r, welfare equals U (B) + δU (y − (1 + r)B).
Borrowing increases utility in period zero, when the proceeds are consumed, but lowers utility
in period one, when households pay for their borrowing. Rational, informed households trade
off the good and bad side of borrowing; they borrow until the marginal utility of consuming
another unit today just equals the marginal, discounted disutility of repaying the extra debt
on payday:
U 0(B) = δ(1 + r)U 0(y − (1 + r)B). (1)
Equation (1) determines household loan demand as a function of their income, their
discount rate, and the market interest rate: B(y, δ, r). For standard utility functions,
household loan demand is increasing in income and decreasing in the discount factor and
interest rate: By > 0; Bδ < 0; Br < 0. Household welfare with optimal borrowing equals
U (B(y, r, d))+δU (y − (1+r)B(y, r, δ)). As long as households follow (1), their welfare with
positive borrowing must be higher than without (autarky).
The welfare gain from borrowing depends on the cost of credit production. Suppose the
cost of lending $B to a particular household equals (1 + ρ)B + f, where ρ represents the
opportunity cost per unit loaned and f is the fixed cost per loan. Think of f as the cost
of record-keeping and credit check required for each loan, however large or small the loan
may be. If the going price for loans is (1+r) per unit borrowed, the lenders’ profits equal
(r − ρ)B − f.
With perfect competition among lenders, the loan interest rate is competed down until
it just covers the costs of the loan: r = ρ + f /B. Equilibrium r and B are determined
where that credit supply curve equals demand (1).
Equilibrium in the payday credit market is illustrated in Figure (3). If fixed costs per loan
are prohibitively high, the market may not exist. Perhaps the payday lending technology
lowered the fixed cost per loan enough to make the business viable.3 Before the advent of
payday lending, households who applied to banks for a very small, short-term loan may have
been denied.
Fixed costs per loan imply that smaller loans will cost more per dollar borrowed than
larger loans. That means households with low credit demand will pay higher rates than
households with high loan demand. Loan demand is increasing in income, so high income
households who demand larger quantities of credit will enjoy a ”quantity” discount, while
lower income households will pay a ”small lot” premium, or penalty. That price ”discrimination”
is not invidious, however; the higher cost of smaller loans reflects the fixed costs of
lending. The high price of payday loans may partly reflect the combination of fixed costs
and small loan amounts (Flannery and Samolyk 2005).
A usury limit lowers household welfare. Suppose the maximum legal interest rate is r.
At that maximum rate, the minimum loan that lenders’ cost is f /(r− ρ) = B. Low income
households with loan demand less than B face a beggar’s choice: borrow B at r or do not
borrow at all. Such households would be willing to pay more to to avoid going without
credit, so raising the usury limit would raise welfare for those households.
Competition is another key determinant of how much households gains from borrowing.
3Alternatively, or additionaly, the demand for small, short term loans may have increased in the mid
1990s. The welfare reform then almost certainly increased demand for such credit as households who once
”worked” at home for the government were forced to go to work in the market.
Even with no competition — monopoly—households cannot be worse off than under autarky.
The monopolist raises interest rates until the marginal revenue from higher rates equals the
marginal cost from lower loan demand:
B(y, r) = −(r − ρ)Br(y, r). (2)
At that monopoly interest rate, rm, household loan demand equals B(y, rm).Household welfare
under monopoly equals U (Br(y, rm))+δU (y −(1+rm)Br(y, rm)). Welfare is lower under
monopoly because credit costs more and their standard of living fluctuates more (because
costly credit reduces their demand for credit) If households borrow from the monopolist,
however, they must better off than without credit.
In sum, welfare for rational households is highest if credit is available at competitive
prices. If households choose to borrow, they must be at least as well off as they were
without credit. Limiting loan rates cannot raise household welfare and may reduce it.
Monopoly lenders lower household welfare, but even with a monopolist, households cannot
be worse off than without credit.
The high cost of payday lending may partly reflect fixed costs per loan. Before payday
lending, those fixed costs may have been prohibitive; very small, short-term loans may not
have been worthwhile for banks. The payday lending technology may have lowered those
fixed costs, thus increasing the supply of credit to low income households demanding small
loans. That version of the genesis of payday lending suggests the innovation was welfare
improving, not predatory.
In the textbook model household welfare cannot be lower than under autarky because households
are fully informed and rational. Here we show households how can be made worse off
than without credit if predatory lenders can delude households about their (households’)
future income.
Suppose that by spending C(τ ), lenders can convince a prospective borrower that her
income on payday will be y +τ. The cost C can be interpreted variously as the cost of a guilty
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Normally, you have to pay back a payday loan on or before your next payday (usually in two weeks or less). The amount you can borrow is usually limited to 30 percent of the net amount of your pay cheque. The net amount of your pay cheque is your total pay, after any deductions such as income taxes. For example, if your pay cheque is $1,000 net every two weeks, your payday loan could be for a maximum of $300 ($1,000 x 30%).
Before giving you a payday loan, lenders will ask for proof that you have a regular income, a permanent address and an active bank account. Some payday lenders also require that you be over the age of 18.
To make sure you pay back the loan, all payday lenders will ask you to provide a postdated cheque or to authorize a direct withdrawal from your bank account for the amount of the loan, plus all the different fees and interest charges that will be added to the original amount of the loan. The combination of multiple fees and interest charges are what make payday loans so expensive (Click here for an explanation of the various fees associated with these types of loans.
The lender should also ask you to sign a loan agreement. If the lender does not offer to give you a copy of the loan agreement, ask for one. Read this document carefully before signing it, and keep a copy for your records
How and when do I pay back the loan?
A payday loan agreement usually says that you must pay the total amount you owe for the loan on or before the date stated in your loan agreement. This includes the amount you borrowed, plus interest and any additional fees and charges.
Some lenders will cash your postdated cheque or process your direct withdrawal on the day the loan is due. However, some lenders may require that you pay the loan in cash, on or before the due date.
If you have not paid the loan in cash by the due date, some lenders may cash your cheque or process the direct withdrawal you signed on the day after your loan's due date, and charge you another fee. Ask the lender what the most inexpensive way is for you to repay your loan.
How does a payday loan affect my credit report?
Credit-reporting agencies collect information on whether or not you make your payments on time. This information, also called your "credit history", is part of your credit report and is used to calculate your credit score.
Making payments on time can help improve your credit score by demonstrating that you are able to manage your debt. Even if you have poor credit, you can rebuild it by using a credit card or other type of credit and paying back the money you owe on time.
This is not the case with payday loans. Since payday lenders are not currently members of the main credit-reporting agencies, getting a payday loan and paying it off on time will not improve your credit score. However, if you do not pay your loan back on time and it is sent to a collection agency, this will likely be reported to a credit-reporting agency and could have a negative impact on your credit report.
How much will a payday loan cost?
A payday loan is much more expensive than most other types of loans offered by financial institutions such as banks or credit unions. Before you apply for a payday loan, find out about all the fees and charges you will have to pay — including the fees you will be charged if you cannot repay the loan on time. The fees may not be easy to see right away, so read the agreement carefully before signing it. If you do not receive an explanation of all of the fees, charges and interest that will apply to the loan, or if you are not satisfied with the explanation you receive, do not sign the loan agreement.
How does the cost of a payday loan compare with other credit products?
Payday loans are much more expensive than other types of loans, including credit cards. But how much are you really paying? How does the cost of a payday loan compare with taking a cash advance on a credit card, using overdraft protection on your bank account or borrowing on a line of credit?
Let's compare the cost of using different types of loans. We'll assume that you borrow $300, for 14 days. Note the considerable difference in the cost of each type of loan.
Things to consider before you apply for a payday loan
Even if you think you may be turned down, ask your bank or credit union for overdraft protection on your bank account, or a line of credit. These are relatively inexpensive ways of obtaining access to extra funds, for short-term use.
If you are turned down for any of these credit options, ask why. If the reason is that you have a poor credit history, contact the three credit-reporting agencies to get a copy of your credit report. Read the reports carefully to make sure that all of the information in it is correct. If you find any errors, contact the credit-reporting agency to find out how you can have the information corrected. The three major credit-reporting agencies in Canada are Equifax Canada, TransUnion Canada and Northern Credit Bureaus. All three of these agencies will give you a copy of your credit report for free if you request that it be sent to you by regular mail.
Ask yourself if you really need to take out a loan, or whether you can get by until your next pay cheque. If you need the money immediately, try to make other arrangements. For example, you may be able to cash in vacation days. Or you might consider getting a short-term loan from a family member or a friend.
If you find that you need to apply for a payday loan because you have no alternative, only borrow an amount that you are 100 percent sure you can repay on the due date of the loan.
Don't borrow more than you need.
Things to consider if you take out a payday loan
Don't be afraid to ask a lot of questions. Read carefully — and take home with you — a copy of the loan agreement that you are being asked to sign. Don't feel pressured to sign the loan agreement right away if you have questions and want more time to read through the agreement on your own. If the lender does not want to give you a copy of the agreement, look for another lender.
Be sure to ask about all the fees, charges and interest that apply when you first get the loan, and what other charges you will owe if you can't pay the loan back on time.
If you are taking out a payday loan at another location to pay back the first payday loan, or you are extending or "rolling over" the loan that you had with the same lender, you could find yourself in serious financial difficulty. The fees, charges and interest will add up quickly on these types of loans, which can put you into serious debt.
How can I figure out the cost of each type of loan?
To estimate the total cost of a loan, including the annual cost of the loan expressed as a percentage of the amount borrowed, follow the steps below.
Step 1:
Determine how much interest you will pay. First, find out the annual interest rate that applies to the loan (if there is one). Figure out the daily interest rate by dividing the annual interest rate of the loan by 365 days. Then, multiply that rate by the length of time you are taking the loan. Finally, multiply the result by the amount you will borrow, in dollars:
Amount of interest
= Annual interest rate
--------------------------------------------------------------------------------
365 days × Length of the loan
(number of days) × Amount of the loan
Step 2:
Determine the total cost of the loan by adding any fees that may apply to the interest you will have to pay. Find out what fees apply to the loan and add them to the cost of the interest, found in Step 1:
Total cost of the loan = Amount of interest + Total fees
Step 3:
Estimate the annual cost of the loan, expressed as a percentage of the amount borrowed. First, divide the total cost of the loan, found in Step 2, by the amount of the loan. Then, divide this rate by the length of time you are taking the loan (in days) and multiply it by 365 (the number of days in the year):
Annual cost of the loan (%)
= Cost of the loan
--------------------------------------------------------------------------------
Amount of the loan ÷ Length of the loan
(number of days) × 365 days
Let's find out the cost of a $300 payday loan, taken for 14 days.
We'll assume that the lender charges you a one-time set-up fee of $10 and a service fee of $40, which includes interest on the loan.
Step 1:
Determine how much interest you will pay. In this case, there is no interest fee. The interest is therefore $0.
Step 2:
Figure out the cost of the loan by adding together any fees that apply and the interest you will have to pay. In this case, you would add the $10 set-up fee and the $40 service fee together:
$10 + $40 = $50
Step 3:
Estimate the total annual cost of the loan, expressed as a percentage of the amount borrowed:
Annual cost of the loan (%)
= Cost of the loan
--------------------------------------------------------------------------------
Amount of the loan ÷ Length of the loan
(number of days) × 365 days
= $50
———— ÷ 14 days × 365 days
$300
= 4.35 or approximately 435%
The total cost of the payday loan would be $50 with an annual cost of 435 percent of the amount borrowed.
Information asymmetries are common in credit market models, but the usual assumption,
at least in commercial lending, is that borrowers are the better informed party and that
lenders have to screen and monitor to assess whether firms are creditworthy. The opposite
asymmetry, as we assume here, does not seem implausible in the context of consumer lending.
“Fringe” borrowers are less educated than mainstream borrowers (Caskey 2003), and many
are first-time borrowers (or are rebounding from a failed first foray into credit). Lenders
know from experience with large numbers of borrowers, whereas the borrower may only have
their own experience to guide them. Credit can also be confusing; after marriage, mortgages
are probably the most complicated contract most people ever enter. Given the subtleties
involved with credit, and the supposed lack of sophistication of sub-prime borrowers, our
assumption that lenders know better seems plausible.
While lenders might deceive households about several variables that influence household
loan demand, we focus on income. We suppose that lenders exaggerate household’s future
income in order boost loan demand. Our borrowers are gullible, in the sense that they can
be fooled about their future income, but they borrow rationally given their beliefs. Fooling
borrowers is costly to lenders, where the costs could represent conscience, technological costs
(of learning the pitch), or risk of prosecution. The upside to exaggerating borrowers’ income
prospects is obvious—they borrow more. As long as the extra borrowing does not increase
default risk too much, and as long as deceiving borrowers is easy enough, income deception
and predatory—welfare reducing—lending may occur.
After defining predatory lending, we test whether payday lending fits our definition. Payday
lenders make small, short-term loans to mostly lower-middle income households. The
business is booming, but critics condemn payday lending, especially the high fees and frequent
loan rollovers, as predatory. Many states prohibit payday loans outright, or indirectly,
via usury limits.
To test whether payday lending qualifies as predatory, we compared debt and delinquency
rates for households in states that allow payday lending to those in states that do not. We
focus especially on differences across states households that, according to our model, seem
more vulnerable to predation: households with more income uncertainly or less education.
We use smoking as a third, more ambiguous, proxy for households with high, or perhaps
hyperbolic, discount rates. In general, high discounters will pay higher future costs for a
given, immediate, gain in welfare. Smokers’ seem to fit that description. What makes the
smoking proxy ambiguous is that smokers may have hyperbolic, not just high, discount rates.
Hyperbolic discount rates decline over time in a way that leads to procrastination and selfcontrol
problems (Laibson 1997). The hyperbolic discounter postpones quitting smoking,
or repaying credit. Without knowing whether smokers discount rates are merely high, or
hyperbolic, we will not be able to say whether any extra debt for smokers in payday states
is welfare reducing.2
Given those proxies, we use a difference-in-difference approach to test whether payday
lending fits our definition of predatory. First we look for differences in household debt
and delinquency across payday states and non-payday states, then we test whether those
difference are higher for potential prey. To ensure that any such differences are not merely
state effects, we difference a third time across time by comparing whether those differences
changed after the advent of payday lending circa 1995. That triple difference identifies any
difference in debt and delinquency for potential prey in payday states after payday lending
was introduced.
Our findings seem mostly inconsistent with the hypothesis that payday lenders prey on,
i.e., lower the welfare of, households with uncertain income or households with less education.
Those types of households who happen to live in states that allow unlimited payday loans
are less likely to report being turned down for credit, but are not more likely, by and large,
to report higher debt levels, contrary to the overborrowing prediction of our model. Nor are
such households more likely to have missed a debt payment in the previous year. On the
contrary, households with uncertain income who live in states with unlimited payday loans
are less likely to have missed a debt payment over the previous year. The latter result is
consistent with claims by defenders of payday lending that some households borrow from
2Consistent with a high discount rate, Munasinghe and Sicherman (2000) discover that smokers have
flatter wage profiles and they are willing to trade more future earnings for a given increase in current earnings.
Gruber and Mulainathan (2002) find that high cigarette taxes make smokers ”happier,” consistent with
hypberbolic discount rates (because taxes help smokers commit to quitting). DellaVigna and Malmendier
(2004) show how credit card lenders can manipulate hyperbolic discounters by front-loading benefits and
back-loading costs.
payday lenders to avoid missing payments on other debt. On the whole, our results seem
consistent with the hypothesis that payday lending represents a legitimate increase in the
supply of credit, not a contrived increase in credit demand.
We find some interesting differences for smokers, but those differences are harder to
interpret in relation to the predatory hypothesis without knowing apriori whether smokers
are hyperbolic, or merely high, discounters.
We also find, using a small set of data from different sources, that payday loan rates
and fees decline significantly as the number of payday lenders and pawnshops increase.
Reformers often advocate usury limits to lower payday loan fees but our evidence suggests
that competition among payday lenders (and pawnshops) works to lower payday loan prices.
Our paper has several cousins in the academic literature. Ausubel (1991) argues that
credit card lenders exploit their superior information about household credit demand in their
marketing and pricing of credit cards. The predators in our model profit from their information
advantage as well. Our concept of income delusion or deception also has a behavioral
flavor, as well, hence our use of smoking as a proxy for self-control problems. Brunnermeier
and Parker (2004), for example, imagine that households choose what to expect about future
income (or other outcomes). High hopes give households’ current “felicity,” even if it
distorts borrowing and other income-dependent decisions. Our households have high hopes
for income, and they make bad borrowing decisions, but we do not count the current felicity
from high hopes as an offset to the welfare loss from overborrowing.
Our costly falsification (of household income prospects) and costly verification (by counselors)
resemble Townsend’s (1979) costly state verification and Lacker andWeinbergs’ (1989)
costly state falsification. The main difference here is that the falsifying and verifying comes
before income is realized, not after.
More importantly, we hope our findings inform the current, very real-world debate,
around predatory lending. The stakes in that debate are high: millions of lower income
households borrow regularly from thousands of payday loan offices around the country. If
payday lenders raise household welfare by relaxing credit constraints, anti-predatory legislation
may lower it.
Payday lenders make small, short-term loans to households. The typical loan is about $300
for two weeks. The typical fee is $15 per $100 borrowed. Lenders require two recent pay
stubs (as proof of employment), and a recent bank account statement. Borrowers secure
the loan with a post-dated personal check for the loan amount plus fees. When the loan
matures, lenders deposit the check.
Payday lending evolved from check cashing much like bank lending evolved from deposit
taking. For a fee, check cashiers turn personal paychecks into cash. After cashing several
paychecks for the same customer, lending against f uture paychecks was a natural next step.
High finance charges is the main criticism against payday lenders. The typical fee of $15
per $100 per two weeks implies an annual interest rate of 15x365/14, or 390 percent. Payday
lenders are also criticize for overlending, in the sense that borrowers often refinance their
loans repeatedly, and for ”targeting” women making the transition from welfare-to-work
(Fox and Mierzewski 2001) and soldiers (Graves and Peterson 2004).
Despite their critics, payday lending has boomed. The number of payday advance offices
grew from 0 in 1990 to 14, 000 in 2003 (Stegman and Harris 2003). The industry originated
$8 to $14 billion in loans in 2000, implying 26-47 million individual loans. Rapid entry
suggests the industry is profitable.
Payday lenders present stiff competition for pawnshops, even though the internet, namely
E-bay, significantly foreclosure costs for pawnshops (Caskey 2003). The number of pawn
shops in the U.S. grew about six percent per year between 1986 and 1996, but growth
essentially stalled from 1997 to 2003. Prices of shares in EZCorp, the largest, publicly
traded pawn shop holder, were essentially flat or declining between 1994 and 2004, while
Ace Cash Express share prices, a retail financial firm selling check cashing and payday loans,
rose substantially over that period (Figure 4). EZCorp CEO, Joseph Rotunday, blamed
payday lenders for pawnshops’ dismal performance:
The company had been progressing very nicely until the late 1990s.... (when)
a new product called payroll advance/payday loans came along and provided our
customer base an alternative choice. Many of them elected the payday loan over
the traditional pawn loan. (Quoted by Caskey (2003) p.14).
Payday lending is heavily regulated (Table 1). As of 2001, eighteen states effectively
prohibited payday loans via usury limits, and most other states prices, loan size, and loan
frequency per customer (Fox and Mierzwinski 2001). Note that the payday loan limit ranges
from 0 (where payday loans are illegal) to 1250. Nine states allow unlimited payday loans.
Payday lenders have circumvented usury limits by affiliating with national or state
chartered banks, but the Comptroller of the Currency—the overseer of nationally chartered
banks–recently banned such affiliations. The Federal Deposit Insurance Corporation still
permits payday lenders to affiliate with state banks, but recently restricted those partnerships
(Graves and Peterson 2005).
Regulatory risk—the threat of costly or disabling legislation in the future—looms large for
Payday lenders. The Utah legislature is reconsidering its permissive laws governing payday
lending. North Carolina recently drove payday lenders from the state by expressly outlawing
the practice.
Heavy regulation increases the cost of payday lending. High regulatory risk increases limits
entry into the industry and increases the expected return required by industry investors.
Driving up costs and driving away investors may be exactly what regulators intended if they
view payday lending as predatory.
We define predatory lending as a welfare reducing provision of credit. Households can be
made worse off by borrowing if lenders can deceive households into borrowing more than is
optimal. Excess borrowing reduces household welfare, and may increase default risk.
We illustrate our concept of predatory lending in a standard model of household borrowing.
Before we get to predatory lending, we review basic principles about welfare improving
lending, the type that lets households maintain their consumption despite fluctuations in
their income.
The model has two periods: today (period zero) and payday (period one. Household income
goes up and down periodically, but not randomly (for now): income equals zero today
and y on payday. If households consume Ct in period t, their utility is U (Ct).Household welfare
is the sum of utility over both periods: U (C0)+δU (C1), where δ equals the household’s
time rate of discount. Households with high δ value current consumption highly relative to
future consumption. In other words, high discounters are impatient.
A digression here on discount rates serves later discussion. In classical economics δ is
constant. If δ changes over time, so does household behavior, even if nothing else changes.
If δ(t) is hyperbolic, households will postpone unpleasant tasks until current consumption
does not seem so precious relative to future consumption (Laibson 1997). With hyperbolic
discounting, that day never arrives, so hyperbolic discounters have behavioral problems: they
procrastinate. They may never repay debt, much less begin saving. Hyperbolic discounters
who start smoking may never quit.
Returning to the model, if the marginal utility of consumption (U 0) is diminishing, households
will demand credit to reduce fluctuations in their standard of living. Households
without credit, however, must fend for themselves (autarky). Welfare under autarky equals
U(0)+δU (y). The fluctuations in consumption for households without credit make autarky
a possible worst case, and hence, a good benchmark for comparing cases with credit.
If households borrow B at interest rate r, welfare equals U (B) + δU (y − (1 + r)B).
Borrowing increases utility in period zero, when the proceeds are consumed, but lowers utility
in period one, when households pay for their borrowing. Rational, informed households trade
off the good and bad side of borrowing; they borrow until the marginal utility of consuming
another unit today just equals the marginal, discounted disutility of repaying the extra debt
on payday:
U 0(B) = δ(1 + r)U 0(y − (1 + r)B). (1)
Equation (1) determines household loan demand as a function of their income, their
discount rate, and the market interest rate: B(y, δ, r). For standard utility functions,
household loan demand is increasing in income and decreasing in the discount factor and
interest rate: By > 0; Bδ < 0; Br < 0. Household welfare with optimal borrowing equals
U (B(y, r, d))+δU (y − (1+r)B(y, r, δ)). As long as households follow (1), their welfare with
positive borrowing must be higher than without (autarky).
The welfare gain from borrowing depends on the cost of credit production. Suppose the
cost of lending $B to a particular household equals (1 + ρ)B + f, where ρ represents the
opportunity cost per unit loaned and f is the fixed cost per loan. Think of f as the cost
of record-keeping and credit check required for each loan, however large or small the loan
may be. If the going price for loans is (1+r) per unit borrowed, the lenders’ profits equal
(r − ρ)B − f.
With perfect competition among lenders, the loan interest rate is competed down until
it just covers the costs of the loan: r = ρ + f /B. Equilibrium r and B are determined
where that credit supply curve equals demand (1).
Equilibrium in the payday credit market is illustrated in Figure (3). If fixed costs per loan
are prohibitively high, the market may not exist. Perhaps the payday lending technology
lowered the fixed cost per loan enough to make the business viable.3 Before the advent of
payday lending, households who applied to banks for a very small, short-term loan may have
been denied.
Fixed costs per loan imply that smaller loans will cost more per dollar borrowed than
larger loans. That means households with low credit demand will pay higher rates than
households with high loan demand. Loan demand is increasing in income, so high income
households who demand larger quantities of credit will enjoy a ”quantity” discount, while
lower income households will pay a ”small lot” premium, or penalty. That price ”discrimination”
is not invidious, however; the higher cost of smaller loans reflects the fixed costs of
lending. The high price of payday loans may partly reflect the combination of fixed costs
and small loan amounts (Flannery and Samolyk 2005).
A usury limit lowers household welfare. Suppose the maximum legal interest rate is r.
At that maximum rate, the minimum loan that lenders’ cost is f /(r− ρ) = B. Low income
households with loan demand less than B face a beggar’s choice: borrow B at r or do not
borrow at all. Such households would be willing to pay more to to avoid going without
credit, so raising the usury limit would raise welfare for those households.
Competition is another key determinant of how much households gains from borrowing.
3Alternatively, or additionaly, the demand for small, short term loans may have increased in the mid
1990s. The welfare reform then almost certainly increased demand for such credit as households who once
”worked” at home for the government were forced to go to work in the market.
Even with no competition — monopoly—households cannot be worse off than under autarky.
The monopolist raises interest rates until the marginal revenue from higher rates equals the
marginal cost from lower loan demand:
B(y, r) = −(r − ρ)Br(y, r). (2)
At that monopoly interest rate, rm, household loan demand equals B(y, rm).Household welfare
under monopoly equals U (Br(y, rm))+δU (y −(1+rm)Br(y, rm)). Welfare is lower under
monopoly because credit costs more and their standard of living fluctuates more (because
costly credit reduces their demand for credit) If households borrow from the monopolist,
however, they must better off than without credit.
In sum, welfare for rational households is highest if credit is available at competitive
prices. If households choose to borrow, they must be at least as well off as they were
without credit. Limiting loan rates cannot raise household welfare and may reduce it.
Monopoly lenders lower household welfare, but even with a monopolist, households cannot
be worse off than without credit.
The high cost of payday lending may partly reflect fixed costs per loan. Before payday
lending, those fixed costs may have been prohibitive; very small, short-term loans may not
have been worthwhile for banks. The payday lending technology may have lowered those
fixed costs, thus increasing the supply of credit to low income households demanding small
loans. That version of the genesis of payday lending suggests the innovation was welfare
improving, not predatory.
In the textbook model household welfare cannot be lower than under autarky because households
are fully informed and rational. Here we show households how can be made worse off
than without credit if predatory lenders can delude households about their (households’)
future income.
Suppose that by spending C(τ ), lenders can convince a prospective borrower that her
income on payday will be y +τ. The cost C can be interpreted variously as the cost of a guilty
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