The Payday Loan Puzzle: A Credit Scoring Explanation

Tsung-Hsien Li () and Jan Sun ()

CRC TR 224 Discussion Paper Series from University of Bonn and University of Mannheim, Germany

Abstract: Many credit cardholders in the U.S. turn to expensive payday loans, even though they have not yet exhausted their credit lines. This results in significant monetary costs and has been coined the “Payday Loan Puzzle.” We propose the novel explanation that households use payday loans to protect their credit scores since payday lenders do not report to credit bureaus. To quantitatively examine this hypothesis, we build a two-asset Huggett-type model with two default options as well as hidden information and actions. Using our calibrated model, we can account for 40% of the empirically identified payday loan borrowers with liquidity left on their credit cards. We can also match the magnitude of monetary costs due to this seeming pecuniary mistake. To inform the policy debate over payday lending, we assess the welfare implications of several policy counterfactuals. We find that either banning payday loans or increasing their default costs results in aggregate welfare losses.

Keywords: Consumer Credit; Bankruptcy; Default; Payday Loan; Financial Regulation; Type Score; Asymmetric Information; Hidden Action; Cross-Subsidization (search for similar items in EconPapers)
JEL-codes: D82 E21 E49 G18 G51 K35 (search for similar items in EconPapers)
Pages: 50
Date: 2021-12
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge and nep-mac
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:bon:boncrc:crctr224_2021_324

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