TO the casual observer, the activity of lending to poor and uninformed people at exorbitant interest rates seems inherently predatory. But payday loans, as they are commonly called, are more complicated than they first appear. On the one hand, these loans are rarely repaid all at once. Most are rolled over into new loans, sometimes multiple times, leaving cash-strapped borrowers caught in a cycle of debt. On the other hand, laws to restrict payday loans can prevent borrowers at risk from accessing credit. Some may be forced to seek even more expensive alternatives.

A new article by Amir Fekrazad, an economist at Texas A&M University-San Antonio, illustrates just how complex the question can become. Using a database of millions of loans issued between 2009 and 2013, Mr. Fekrazad analyzed the impact of a law passed by the state of Rhode Island in 2010 that, in effect, reduced the interest rate allowed on a two week payday loan of 15%. (equivalent to an APR, or annual percentage rate, of about 390%) to 10% (APR of 260%). The law aimed to make these loans more affordable. Instead, some borrowers renewed their loans more often, increasing the likelihood of default. The law also had several other unintended consequences: on average, the total number of borrowers increased by 32%, the number of loans per borrower jumped by 3.5% and the principal amount of a typical loan climbed by 3%. %. All of this represented an increase of about 36% in the total volume of payday loans. The poorest have also started to borrow. The average income of a payday borrower has fallen by around 4% (see chart).

These findings can be attributed in part to human psychology. A rational borrower considering a payday loan would weigh the short-term benefit of having additional cash versus the cost of interest payments and potential default, and act accordingly. But Mr Fekrazad says many borrowers overstate the short-term benefits and undervalue the long-term costs, leading them to over-borrow, all the more, it seems, when interest rates fall. . As borrowers go into debt longer, interest owed accumulates and the risk of default increases.

What’s the lesson? On the one hand, policymakers cannot assume that consumers are rational. Mr Fekrazad said Rhode Island could have associated its interest rate cap with a cooling off period, forcing borrowers to wait a set period (ideally longer than a payroll cycle) before taking out another loan. . The state could also have forced lenders to be more transparent. Research has shown that when lenders disclose more information about the future costs of their loans, especially how interest accumulates as debts are renewed, customers tend to borrow less. . Better informed consumers make more rational decisions – it’s an idea you can bring directly to the bank.