Payday Loans With Higher Rates Are Good, Stanford Study Shows

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Online payday loans are a relatively new way for consumers to obtain the short-term cash they need during emergencies. While these loans have been popular with the general public,  critics claim that the cost of payday loans in general is excessive and requires low rate caps. These critics believe that low rates will lead to a greater percentage of loans being funded and a lower rate of loan default.

However, in a study entitled “The Effects of Usury Laws: Evidence from the Online Loan Market” by Stanford University’s Oren Rigbi, we see empirical evidence that just the opposite is true. Borrowers who experienced a low cap did not produce the results the critics would have expected.

Using the latest online tools for analysis

Using data from a lending marketplace Web site called Prosper.com, Rigbi draws a connection between interest rate caps, the probability of faxless payday loan funding, how much a consumer requests and the chance of payment default. Borrowers studied on Prosper.com faced different caps ranging from six to 36 percent in Rigbi’s study, then a “behind-the-scenes change in loan origination” caused rates to normalize at 36 percent in all but one state of borrower origin.

Rigbi found that higher interest rate caps actually

increased the probability that a loan was funded, especially if its borrower was risky and had been previously just “outside the money.” I do not find that borrowers change the loan amounts that they request or that their probability of default rises.

Interest ≠ usury

Indeed, even though common usage in the West is to equate the two, the true definition is rather different.

As he stages the sides of the argument, Rigbi clearly delineates how opposed the two sides are. Opponents argue that capping interest removes high-risk borrowers from being able to obtain payday loans or even establish a credit history. Those who support the cap feel it ultimately “reduces the interest rates a given borrower pays because lenders have market power.”

At this point, Rigbi instructs readers to consider (traditionally) how interest rate caps affect credit markets:

First, higher caps should make lending to higher risk borrowers profitable. That is, higher caps may result in credit being extended to borrowers who were previously denied credit. Second, because the riskiness of a loan depends on its size and not just the identity of the borrower, higher caps may cause a given borrower to request larger loans. Third, higher caps may increase the probability that borrowers default on loans, particularly if the caps were “protecting naive borrowers from themselves.”

Yet the payday loan study results break with tradition

Rigbi finds that the largest increase in payday loan funding occurred for consumers with less than perfect credit. Furthermore, they do not request larger loans when the cap was higher or default more often. This seems to fly in the face of the oft assumed necessity for governments to be responsible for their own populace by levying heavy consumer protections. That, critics feel, is the only way consumers obtain a fair price for credit. However, based on this study’s findings, higher interest rates did not produce negative results, but profitable ones for lenders and positive outcomes for borrowers of payday loans.