Pay Day Lending and Social Networks

There is a long running joke in my family that I borrow money from my parents like poor tropical countries do/did from the World Bank. The loans are always soft (no interest), and for various reasons repayment is often waived. If I am going through a period of unusually high revenue, I am always quick to repay back, but otherwise, the principal may remain unchanged for months or even years. The analogy ends in that my parents have never forced any Washington Consensus like behavior change as a precondition of my borrowing.

There are three main points I am attempting to get across by giving the reader this tidbit from my personal life: 1) I have kind, perhaps not stern enough parents, 2) I do not take great pride in my financial independence from my parents, 3) Social networks and social capital are what allow people to attain cheap short term loans.

One of the truly disastrous debt cycles Americans often fall into is that of the recurring pay day loan. In an article published by the Fannie Mae Foundation, payday lenders are described as:

“institutions that offer small consumer loans of $100 to $300—routinely charge 15 percent per two-week period. In addition to annualized interest rates of more than 400 percent, such loans encourage households to spend the next paycheck before it arrives, thus encouraging a dangerous cycle that can trap a household in permanent debt.”

There are a few parts of this definition I object to. First, I hate the use of “annualized interest rates of more than 400 percent” as if this were a crime (though, in truth, in Canada it actually is a crime). When an individual takes a short term loan (in this case two weeks) from a profit making institution, the annualized interest will almost always be enormous. The bank has to pay for their transaction fees, so it is necessary for the institution to charge a significantly higher interest rate on a two week loan than the bank would for a one year term loan. Second, the quote from Fannie Mae makes it sound like the institutions who offer these loans are doing so with the intent of encouraging “households to spend the next paycheck before it arrives,” when in fact it is the total opposite, people choose to take on debt because they WANT to spend that money before it arrives. Otherwise why not just wait?

I don't enjoy defending the economically libertarian view of payday lending, but it is rarely helpful to start any discussion of a financial instrument for which there is a clear demand with the belief that the instrument itself is evil.

Yet payday lending can lead to a wealth diluting cycle. This pernicious cycle that often results from borrowing against your next paycheck goes something like this. The example bel0w assumes that you are poor (400 dollars every two weeks) and living on the margins, check to check:

Weeks 1-2
-You normally spend 400 dollars per week but this week you need 200 Dollars for an unexpected expenditure (perhaps a medical emergency)
-You have 300 Dollars in the bank at the moment after spending 100 dollars from your last check on groceries.
-You decide to borrow against your next paycheck from a payday lender.

-You borrow 400 Dollars that you will pay back when you get your next paycheck (that is ten days from now), and you will have to pay 40 dollars extra in interest
-Now you are able to spend 600 dollars in this two week period

Paycheck Comes
-The paycheck is 400 dollars.
-After giving this paycheck to the payday lender and paying him 40 dollars in interest, you realize that you only have 60 dollars in the bank for the next two weeks.
-The payday lender offers you the same deal of borrowing 400 dollars against your next paycheck for a 40 dollar interest fee. With no better options, you accept this deal and you now have 460 dollars.

Weeks 3-4
-You attempt to budget your self to spend only 150 dollars in these two weeks
-With a family and other needs, it is just too hard, and you find that you only have 80 dollars left at the end of the two week period

Paycheck Comes

-You decide to again take the offer of another loan from the payday lender.

-Despendondent, you realize that you have already given the payday lender 120 dollars for what was originally a 400 dollar loan, and there is no way out of this spiral.

In that most venerable of resources, the Wikipedia entry, it is written, “Critics blame payday lenders for exploiting people's financial hardship for profit. They say lenders target the young and the poor, particularly those near military bases and in low-income communities. They also say that borrowers may not understand that the high interest rates are likely to trap them in a "debt-cycle," where they have to repeatedly renew the loan and pay associated fees every two weeks until they can finally save enough to pay off the principal and get out of debt.”

Payday lenders certainly do benefit from the “financial hardship” of their customers. I also don’t doubt that there are plenty of scurrilous payday lenders out there. But let us remember this is an economic option of last resort. This is a financial instrument used by those who either are unaware, don’t have time or simply cannot access cheaper sources of funds.

Let’s use my life as an example again. 2 months ago I was in India, as I am today, and my father called to tell me that I needed to pay 1,000 dollars in US taxes. For various reasons all having to do with my numerous vices, I did not have enough money at the moment to send my father. He suggested that he would pay the taxes, and I would owe him 1,000 dollars, which I could pay him back for next time I saw him.

Now let’s assume I did not have access to money from my father. I suppose I would have asked one of closest friends, and I think they probably would have ponied up. But if my friends did not agree, I would be in a serious bind because I only had one month to pay and I don’t have great credit. I would probably go to the bank and see whether they had a loan product they might deign to offer me. If the bank did not have a loan product that could quickly be disbursed, I probably would have gone to a payday lender.

As you see, my defense against the payday lender was not primarily formal finance but rather my friends and family. Of course, it does not hurt that my friends and family are from an moderately high economic class, but I don’t think that tells the whole story. A working paper by Orlanda Ruthven, Money Mosaics: Financial Choice & Strategy in a West Delhi Squatter Settlement, essentially argues that that the social relationships you have and cohesion within your social group are just as important as your economic status. Ruthven describes the internal lending within members of the Nath caste, “Among the Naths, credit needs are overwhelmingly fulfilled by intermittent lenders and such private loans on interest – along with bank accounts – are the most widely used financial devices of Naths. Through social leverage and the assurance of a convergent lifestyle (i.e the low chance that a borrower would somehow move on or disappear), lenders are able to maintain rates at unbeatably low rates enjoyed by no-one else in the colony.” Importantly, the Naths are by no means the wealthiest group within the settlement. (just to be absolutely clear, I do not think this working paper proves my argument in any way, and I understand that I do not have strong empirical backing for what I am suggesting).

As this blog has become unusually long, I am going to continue my thoughts on what this all means for high interest short term loans in India and Indian microfinance later this week.

In the meantime, linked here is another worthwhile read on the comparatively high prices the poor in America have to pay for financial and other services from the Brookings Institution.