Academic journal article Accounting & Taxation

Could Peer-to-Peer Loans Substitute for Payday Loans?

Academic journal article Accounting & Taxation

Could Peer-to-Peer Loans Substitute for Payday Loans?

Article excerpt

ABSTRACT

Many consumer advocates consider payday loans-short-term, uncollateralized loans with high interest rates- o be predatory. The demand for short-term funding has spurred the quest for a substitute, an effort encouraged and supported by regulators like the Federal Deposit Insurance Corporation. In this paper, we evaluate the potential for online peer-to-peer markets to provide this alternative. We conclude that while certain features of peer-to-peer loans would be well suited (such as their longer terms, larger amounts, and multiple payments), the longer time to fund and the required minimum credit scores for borrowers present meaningful hurdles.

JEL: G18, G21, G28

KEYWORDS: Fringe Lending, Payday Loans, Peer-to-Peer Loans

INTRODUCTION

Payday loans have been called "one of the most expensive forms of credit in the world" (Skiba and Tobacman, 2008). A typical two-week payday loan costs $15 per $100 borrowed - a 391.07% APR, or 3,724% effective annual rate. Opponents accuse these extremely high-interest loans of drawing borrowers into a "debt trap." The industry counters that its rapid growth proves that it is providing a necessary, welfare-enhancing service to its customers.

The fact that customers use payday loans does not imply that these loans are the optimal short-term product. In this paper, we evaluate a potential alternative, peer-to-peer (P2P) loans. In a P2P marketplace, potential borrowers post requests for loans, and potential lenders bid on those that interest them. A lender can bid as little as $25 per loan, so it may take many lenders to fund a successful loan request. This more "democratic" process may lead to a more efficient outcome than can a payday transaction.

To evaluate the potential for the P2P market to provide short-term, unsecured, payday-like credit, we consider both the Prosper platform (the oldest P2P network in the United States, opened in 2006) and its highest-profile competitor, Lending Club. We find that, as the P2P market has evolved, its minimum loan sizes, bids per loan, and terms have all fallen, making it a more viable payday alternative. The biggest hurdles left are access, funding speed, and required credit score. However, we argue some payday customers nonetheless may be better off in the P2P market.

The paper proceeds as follows. In the next two sections, we review and evaluate the literature on payday loans and the payday borrower; this review allows us to characterize the market to which we want to apply the P2P approach. Given this characterization, we then evaluate the potential for P2P loans to serve the typical payday customer. The final section highlights the primary hurdles for short-term borrowers in the peer-to-peer market, suggests areas for future research, and concludes.

LITERATURE REVIEW

P2P loans cannot substitute for payday loans if they do not meet the needs of the payday customer. There is a significant literature describing the payday borrower, although much of it is primarily advocacy - written either by industry apologists or by consumer activists. In this section, we review the (smaller) literature from academics and regulators that more objectively characterizes the payday market. We concentrate on the demographics of the typical payday customer, the costs they incur, the number of loans they use, and the alternatives they have. We will see that payday customers are often lower-income minorities who use multiple short-term loans per year. If peer-to-peer loans are to be a viable substitute, they must meet the needs of this typical payday-loan customer.

One of the earliest studies of the payday market was Elliehausen and Lawrence's 2001 survey, which polled over half of the payday shops in the United States. They found customers who were Goldilocks borrowers, falling in the middle of many demographic categories. These borrowers were neither extremely well- nor poorly educated: almost three-fourths had a high-school diploma or some college. …

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