09. December 2021

Banning Payday Loans Lowers Household’s Welfare, Study Says Press release: Banning Payday Loans Lowers Household’s Welfare, Study Says

Payday loans are subject of an intense and sometimes even grim debate, in particular in the U.S. Advocates emphasise the role of payday loans in smoothing consumption while opponents have long argued that these lenders exploit poor households and should be banned.

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A ban of payday loans can result in welfare losses for households, according to a recent study.
“Current regulatory efforts in the U.S. to curtail or even ban the payday loan sectors may potentially
harm households,” economists Tsung-Hsien Li and Jan Sun from the University of Mannheim argue.
A payday loan is a short-term unsecured loan with a duration of a few weeks for a typically small
amount of around 300 dollars. Among individuals in the U.S. who use both credit cards and payday
loans, two-thirds have at least 1,000 dollars of credit card liquidity left when taking such a loan, according
to other studies.

“This behaviour is seemingly puzzling as payday loans carry very high interest rates corresponding to
annualised percentage rates of several hundred per cent, compared to ten to thirty per cent on credit
cards,” Li and Sun wrote.

The so-called Payday Loan Puzzle is that people do not exhaust their credit card limits to protect their
credit scores, since payday lenders do not report to credit bureaus. As a consequence, households
trade off the long-term reputational benefit of maintaining one’s credit score versus the short-term
cost of borrowing on more expensive payday loans.

Households differ in patience, the authors explain. Impatient households are riskier borrowers for
banks compared to patient ones, due to their propensity to consume rather soon than later. However,
banks cannot observe the patience of households and instead use credit scores to assess the riskiness
of their borrowers. If a household is hit by a low income shock, it can borrow using payday loans
to smooth consumption while avoiding a credit score downgrade.

Banks’ limited information leads to a cross-subsidisation in the lending market as impatient households,
who are more likely to use payday loans, are subsidised by patient households, according to Li
and Sun.

To shed more light on the current political debate on regulation in this sector, the authors investigated
welfare implications of limiting access to payday loans through amount caps or an outright ban of
such loans.

If access to payday loans is more constrained, impatient households lose while patient ones gain. Impatient
households are more likely to borrow larger loan sums and are thus more affected by the
quantity cap.

In addition, imposing a cap reduces informational asymmetry in the bank market and hence lowers
the cross-subsidisation of impatient by patient households.

By contrast, a full ban reduces welfare of both household types. The reason for the welfare loss is the
reduction in available insurance, Li and Sun said.

Both impatient and patient households use payday loans to smooth earnings shocks without harming
their credit scores. “With a full ban, the insurance loss outweighs the gains from reduced crosssubsidisation
for patient households,” they noted.

The authors also discuss the repercussions of an increase of default costs. Increasing bankruptcy default
costs leads to welfare gains, whereas increasing only payday default costs leads to welfare losses
for both households.

Increased bankruptcy default costs allow households to get bank loans at lower interest rates, due to
a lower default rate. In contrast, increased payday default costs make it harder for households to
default without damaging their credit scores, which explains the welfare loss in this case, according
to the paper.

“Banning payday loans or increasing their default costs result in aggregate welfare losses,” the authors

The presented discussion paper is a publication without peer review of the Collaborative Research Center (CRC)
Transregio 224 EPoS. Access the full discussion paper here. Find the list of all discussion papers of the CRC here.


  • Tsung-Hsien Li, Ph.D. candidate in economics at the University of Mannheim
  • Jan Sun, member of the Collaborative Research Center Transregio 224 EPoS and Ph.D. candidate in economics
    at the University of Mannheim

Discussion Paper No. 324
Project A 03

The Payday Loan Puzzle: A Credit Scoring Explanation
Tsung-Hsien Li
Jan Sun

For further information and interview requests, please contact the author of the study:
Jan Sun
Department of Economics
Mannheim University
Phone: +49 621-181-1905
Email: jsun@mail.uni-mannheim.de



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