A number of companies exist that specialize in \"payday loans.\" Payday loans ar

Question

A number of companies exist that specialize in "payday loans." Payday loans are small loans often for a few hundred dollars or less that are made to low-income borrowers. Often these borrowers have poor credit histories and few assets and would have difficulty in qualifying for loans from other sources. The interest rates on these loans are often very high and some commentators have suggested that ceilings should be enforced on these loans.

a.Try to apply the lemon’s problem to the market of payday loans and explain what causes the high interest rates in this market.

b.If such interest rate ceilings were imposed, what would be the likely effect?

Explanation / Answer

a)

Since the market for payday loans consist of borrowers with poor credit histories, there are high chances that the borrowers might not repay the loans back. The ones who are in actual need of money would be willing to accept the loan at high interest rates. Also, these high interest rates act as a protective net for lenders, as the number of defaulters will be higher than the good borrowers.

Thus, the inability of lenders to differentiate between good and bad borrowers makes them charge high interest rates, as a compensatory thing.

b)

If ceilings of interest rates charged are imposed, it would lead to lenders withdrawing their money from the market (as their incentive to lend money to earn interest income) would fall.

Also, poor quality borrowers would also get attracted to the market.

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