PAPERS WE’RE READING: “An Overview of Small-Dollar Credit Markets and Related Research”

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In their paper “An Overview of Small-Dollar Credit Markets and Related Research,” Brandon Bolen from Mississippi College, Tom Miller, Professor of Finance at Mississippi State University and Senior Research Fellow at Consumers’ Research, and Gregory Elliehausen, Principal Economist for the Board of Governors for the Federal Reserve System, explain four small-dollar credit products available to consumers.

This paper provides not only a summary of the current debate surrounding four small‐dollar credit products, but also serves as a springboard for researchers in the small-dollar credit market to be informed of the previous research surrounding the debate of these products.

The authors examine pawn transactions, vehicle title loans, payday loans, and traditional cash installment loans from finance companies.

Pawn loans are the most commonly used alternative financial services (AFS) among unbanked Americans. Unlike most types of loans, pawn loans do not obligate the borrower to repay the loan. Consumers are not obligated to repay the money obtained from a pawnbroker.

Vehicle title loans are similar to pawn loans but are larger monetarily. In these loans, the lender has a lien on the vehicle title, but the customer keeps possession of the vehicle. These loans are asset-based, and their sizes vary from 20-55 percent of the vehicle’s value.

Storefront payday loans are collateral on future income. These loans are typically short-term, single-payment loans in which the borrower writes a check to a lender in exchange for a short-term cash loan due when the customer receives his next paycheck. The lender agrees not to cash the check until a date specified in the loan agreement. Online payday loans are similar to storefront payday loans, except that payments are made electronically.

Cash installment loans are small, closed-end cash loans from finance companies repaid in periodic installments of principal and interest.

After detailing the four different small-dollar lending programs, the authors look at prominent economist Irving Fisher’s investment decisions model. Fisher’s model shows that individuals can lend current income or borrow against future income at a single interest rate to obtain a more highly valued time pattern of consumption than allowed by the time pattern for receipt of income.

Subsequent models, Hirschleifer (1958) and Juster and Shay (1964), show that Fisher’s conclusions still hold when the single interest rate assumption is relaxed to reflect actual institutional characteristics of consumer credit markets.

The authors find that evaluating individual decisions on small-dollar credit use is generally impossible despite these models’ existence. However, it is possible to test whether the characteristics of consumers who use these credit markets align with those predicted by the economic theory of the consumers who rationally use small-dollar credit markets.

Bolen, Miller, and Elliehausen examined if pawn, vehicle title, payday, and installment borrowers exhibit characteristics similar to the rational consumer. Part of their evaluation included looking at whether the borrowers understand the products and deliberate in their decision. The authors concluded that the borrowers exhibit thoughtfulness and understanding in using each of the kinds of small-dollar lending products.

According to Bolen, Miller, and Elliehausen, pawn, vehicle title, payday, and installment borrowers all match the description of those who their model predicts will benefit from small-dollar cash credit access. In beginning their assessment of the benefits and harms for consumers who have access to small-dollar cash credit, the authors looked at the existing literature on the issue. The authors conclude that, despite extensive research, the question of whether borrowers are helped or harmed by these products remains unanswered.

The authors then moved on to regulatory structures that manage credit terms and lending practices to prevent lenders from taking advantage of borrowers’ needs and weak bargaining power.

The two regulations intended to protect consumers in credit transactions identified by the authors are direct regulation of firms’ market conduct when offering products or services and direct regulation of product content and price.

“Many small-dollar credit borrowers understand the terms of the credit products, accurately predict their own repayment behavior, and benefit from the availability of small-dollar credit. Though, because some borrowers mispredict their own repayment behavior and experience poor outcomes, policymakers face a tradeoff between the benefits of regulation to these borrowers and the costs of regulation to borrowers that benefit from small-dollar credit use. Bans on small-dollar credit products, through interest rate caps or otherwise, deprive the many borrowers who benefit from small-dollar credit products of much needed credit,” said Bolen to Consumers’ Research.

According to the authors, the ambiguity surrounding the question of if borrowers are helped or harmed by these products factors into why there is disagreement among policymakers, scholars, and others regarding the proper policy response to small-dollar short-term credit.

The authors find that explicit or implicit bans on small-dollar credit products may be depriving borrowers of much-needed credit, but they could also be protecting borrowers from accruing too much debt.

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