The Payday Loan Puzzle: A Credit Scoring Explanation

50 Pages Posted: 17 Dec 2021 Last revised: 27 Jul 2022

See all articles by Tsung-Hsien Li

Tsung-Hsien Li

University of Mannheim - Department of Economics

Jan Sun

University of Mannheim

Date Written: November 1, 2021

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

JEL Classification: D82, E21, E49, G18, G51, K35

Suggested Citation

Li, Tsung-Hsien and Sun, Jan, The Payday Loan Puzzle: A Credit Scoring Explanation (November 1, 2021). Available at SSRN: https://ssrn.com/abstract=3954233 or http://dx.doi.org/10.2139/ssrn.3954233

Tsung-Hsien Li (Contact Author)

University of Mannheim - Department of Economics ( email )

D-68131 Mannheim
Germany

Jan Sun

University of Mannheim ( email )

Mannheim
Germany

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