PAYDAY LOANS SHOULD BE PROHIBITED
Payday loans are defined by Johnson (2002) as short term maturity loans which are offered to borrowers, who are cash strapped, with extremely high interest rates. In my opinion payday loans should be prohibited because:
Cognitive Bias (Bertrand and Morse, 2009)
Bertrand and Morse (2009) state that people unconsciously do not assimilate the overall cost of payday loan which includes fees plus the annual percentage rate (APR); this behaviour of people as referred by many psychologists is called narrow choice bracketing or narrow decision frame. State and federal laws have made compulsory for the lenders of payday loans to make annual percentage rate (APR) clearly known to the borrowers when they take loans but payday loan stores convey their fees to customers in the form of pictures by displaying huge pricing menus due to which the borrowers may overlook annual percentage rate (APR) and might only assimilate dollar fees of the loans. Thus they might wrongly identify fee structure as APR. Chin (2004) mentions that Truth in Lending Act 1968 was bought into existence by Federal Govt to make the borrowers fully informed about the loan conditions so that they are fully protected against unlawful practices. Before the TILA Act 1968 was passed lenders were not required to follow a code of conduct in calculating the interest rates or to conspicuously disclose them. The ancillary expenses were kept hidden by the lenders. Due to this it was difficult for the borrowers to compare and decide among the sources of credit available to them. This indecisiveness on the part of borrowers made it necessary for the regulators to pass TILA Act 1968. Loan conditions are not controlled by the act; rather they make it clear for the borrowers to make the most feasible choices when they want to opt for a loan. Under TILA Act 1968 lenders have to calculate the annual percentage rate and clearly communicate with the borrowers about these finance charges which they will have to incur. Statistics indicate that payday lenders do not obey TILA Act 1968. Bertrand and Morse (2009) have expressed that even if the APR is clearly disclosed by the lenders to the borrowers the financially illiterate borrowers do not understand the importance of APR. APR rates are not of prime importance to them when their only intention is to somehow manage their daily essentials for the current month especially if they have a diminished earning capacity. According to Noyes (2006) they base their decisions on their immediate requirements and not on the cost of credit which they will have to incur later thus making the TILA ACT 1968 fascinating but immaterial based on their behaviour. Bertrand and Morse (2009) convey that borrowers refuse to acknowledge the consequences of transactions which are smaller in amounts because small amounts are considered as peanuts. This theory is popularly known as peanuts effect. Borrowers consider each loan fee as peanuts and ignore the cost which might get added overtime. Borrowers also fail to consider that some fluctuations might occur in their income and expense levels in future due to which there is an over confidence in them regards their ability to repay the loan. Francis (2010) considers this behaviour as Optimism Bias. In Optimism Bias people consider a very low probability of happening something bad with them when compared to others. They assume that they will never get fired from work or will never contract a disease which otherwise is applicable to everyone. They might fail to notice an unexpected expense in future such as a high medical bill or a car repair expense. Similarly payday loan borrowers are also highly positive about having more money and fewer expenses in future and they are confident enough of repaying the loan on the maturity date. Bruch (2001) suggests that procedural unconscionability restrains the borrower and makes him so desperate that he is ready to borrow money from the lender at any cost.
Targeting the underprivileged
Bruch (2001) asserts that payday lenders target the low and middle income groups who don’t have the capacity to repay their loans. “Payday lenders are fully aware that borrower default is almost inevitable, and they are fully aware of the two reasons for this inevitability. The first of these is that borrowers do not make enough money to pay off high-priced loans. One study analyzed the “a bility to r epay” of borrowers earning $25,000 a year and borrowers earning $35,000 a year. This study concluded that a person making $25,000 a year would, without payments on a payday loan, fall $14 a week short on recurring payments for food, housing, healthcare, transportation, and utilities, and a person making $35,000 would have a weekly surplus of $67. These figures do not include emergency payments for car repairs or medical treatment, which points to the second major factor contributing to the high default rate of payday loans; the two-week duration of most payday loans does not give borrowers a chance to recover from the problem that sent them to the payday lender in the first place”. (Bruch, 2001, pp. 1280 -1281). According to Francis (2010) smart lenders also frame the decision of borrowers so as to exploit their underestimation bias that would eventually affect their choice. Bruch (2001) professes that financially desperate people are not only urged by the payday lenders to obtain payday loans but they are also urged by them to continue their journey by taking out multiple loans which only leads to an additional burden to the borrowers in the form of extension fees, additional interest, etc. Francis (2010) points out that the distorted pricing scheme of payday loans set by the lenders is no different from the credit cards where long term component is roll over fees and short term component is initial loan fee. “Long-term element (i.e., the rollover fee) is priced higher relative to marginal costs than the short-term element (i.e., the initial loan fee). Though all the fees are the same dollar amount, the marginal cost of a renewed loan to a repeat borrower is lower than the marginal cost of the initial loan. The costs associated with high-frequency borrowers are much less than the costs of serving low-frequency borrowers and lenders can take advantage of economies of scale. Rather, lenders are able to benefit from borrowers’ systematic underestimation of rolling over their loan and, thus, their inelasticity with respect to the costs of the rollover fee. Payday lenders amass more than 90% of their profits from borrowers who have five or more rollovers during a year. Essentially, this distorted pricing scheme means that repeat borrowers paying multiple rollover fees are cross-subsidizing onetime borrowers who only pay the initial loan charge”(Francis, 2010, p. 632).
Thus, to conclude, it is the borrower’s unpremeditated mind that suppresses their rational behaviour when they have to manage their fundamental needs. This unconsciousness of the borrowers makes them vulnerable to the lenders which puts the lenders in a superior position to take their advantage. The borrowers may think that their urgent needs are being met through payday loans but such kind of short term loans are only sinking them in further debt only to make them realise that they are not able to repay it further. Therefore I believe that the product is not suitable for the borrowers because they depict an insentient behaviour of which the lenders take undue advantage. So the payday loans should be prohibited.
Bertrand, M. and Morse, A. (2009) Information Disclosure, Cognitive Biases and Payday Borrowing. Available at: https://bfi.uchicago.edu/RePEc/bfi/wpaper/BFI_2009-007.pdf (Downloaded: 22 September 2018)
Bruch, Charles. (2001) Taking the Pay Out of Payday Loans: Putting an End to the Usurious and Unconscionable
Interest Rates Charged by Payday Lenders. Available at: https://heinonline.org/HOL/Page?handle=hein.journals/ucinlr69&div=45&g_sent=1&casa_token=&collection=journals (Downloaded: 27 September 2018)
Chin, P. (2004) Payday Loans: The Case for Federal Legislation. Available at: https://heinonline.org/HOL/Page?handle=hein.journals/unilllr2004&id=735&collection=journals&index=
(Downloaded: 27 September 2018)
Francis, K. (2010) Rollover, Rollover: A Behavioural Law and Economics Analysis of the Payday-Loan Industry. Available at: https://heinonline.org/HOL/Page?collection=journals&handle=hein.journals/tlr88&id=617&men_tab=srchresults(Downloaded: 23 September 2018)
Johnson, C. (2002) Payday Loans: Shrewd Business or Predatory Lending. Available at: https://heinonline.org/HOL/Page?collection=journals&handle=hein.journals/mnlr87&id=15&men_tab=srchresults (Downloaded: 30 September 2018)
Noyes, K. (2006) Get Cash until Payday – the Payday-Loan Problem in Wisconsin. Available at: https://heinonline.org/HOL/Page?handle=hein.journals/wlr2006&div=43&g_sent=1&casa_token=&collection=journals (Downloaded: 27 September 2018)