Doctoral Dissertation Research: Payday Loans, Consumption Shocks, and Discounting

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Roughly nine million American households borrowed on payday loans in 2002, typically paying annualized interest rates above seven thousand percent. These loans have a term equal to the duration of one pay cycle, mature on borrowers' paydays, and are collateralized with post-dated personal checks. The total volume of payday loan borrowing increased four-fold from 1999-2003 to a total of $40 billion. With a unique new dataset of nearly 2 million payday loan applications, 1.7 million loans, and 215,000 borrowers, the primary objective of the work funded by this award is to explain why consumers use these extremely expensive financial instruments. Two candidate hypotheses stand out. First, consumers may experience shocks to consumption needs like expenses for health care or car repairs. These shocks could raise the marginal utility of consumption enough to account for borrowing at very high interest rates. Surprisingly little existing economics research has studied consumption shocks, and an important secondary objective of the proposed project is to explore models of consumption shocks and quantify their role in economic decision-making. A second possible explanation for payday borrowing is that consumers might heavily discount utility from future consumption.The research will evaluate these hypotheses. A survey to collect data on payday borrowers' actual consumption expenditures will be used to gather data that directly indicate the magnitudes of consumption shocks. This research will advance knowledge by developing and testing new models of shocks to consumption needs and explaining why people borrow at very high interest rates on payday loans. The richness of the payday loan dataset provides an unusual opportunity to conduct this inquiry, and recent work (Gourinchas and Parker 2002, and Laibson, Repetto, and Tobacman 2004) developed techniques that will beapplied and extended here. In addition, the results of the project may have important broader impacts, particularly for disadvantaged groups in society. Since the median annual income of payday borrowers in the dataset is about $20,000, this research largely pertains to the circumstances and choices of low-income decision-makers. Improvedunderstanding both of the types of shocks poor households face and how they use available financial instruments to deal with that volatility can help policy-makers design effective interventions.