Lindsey Berry borrowed £ 10 from online money lender Wonga. Weeks later, interest charges, late payment fees and bank overdraft penalties inflated her debt, and she found herself owing £ 85 with no money to buy food.
Cases like Lindsey’s are on the rise in the wake of the financial crisis: Payday-related calls to National Debtline advisory service have increased 4,200% since 2007. But payday loan companies such as Wonga have cashed in, enjoying annual profits of £ 62.5 million as cash strapped consumers turn to short term loans with insanely high interest rates.
In July, the Archbishop of Canterbury made waves when he said the Church of England would seek to “compete [Wonga] the £ 2 billion a year payday loan industry is currently under investigation by the Competition Commission after the Office of Fair Trading discovered evidence of irresponsible lending practices. Wonga recently raised its standard interest rate to 5.853% APR – meaning if you took out a £ 10 loan you owed £ 585 in interest a year later.
Why would anyone sign up for such a crude deal? Psychological research can help explain how payday lenders have such a powerful – and toxic – allure. Payday lenders are taking advantage of people’s tendency to discount the future: Remote rewards are worth less than immediate rewards.
To give an example of how the discount works: £ 10 today may seem as good as £ 15 in a week, because the value of the future is £ 15 is reduced. People differ a lot in the extent to which they discount future rewards. John might prefer £ 10 today to £ 20 a week from now, while Bill might prefer £ 11 a week to £ 10 today. John is a steeper discount, which means he’s much more likely than Bill to take out a payday loan.
If John borrowed £ 10 from Wonga, he should £ 16.59 in a week – a godsend, given that £ 10 today is subjectively worth more to him than £ 20 in a week. When John takes out the loan, his decision is perfectly “rational” in the sense that it corresponds to his preferences. The problem arises later when the bill comes due: The £ 16.59 John now owes is no longer discounted, so the refund hurts – causing John to regret his earlier decision.
Neuroscience research suggests that exposure to stress can negatively impact people’s economic decision making. Recent studies have shown that the prefrontal cortex is essential for patiently awaiting future rewards; disturb the function of the prefrontal cortex with electrical stimulation makes people look to the future more strongly.
Unfortunately, the prefrontal cortex is very sensitive disruption due to chronic stress, and the latest evidence suggests that stress hormones and stressful experiences make people more discounted for the future. This means that the pressures of financial hardship can alter the prefrontal cortex, making consumers even more likely to decide to take out a short-term loan than they would otherwise under less stressful circumstances.
Visit the Wonga website and the first thing you will notice is that you can get up to £ 400 in just 5 minutes after your loan is approved. New search suggests that these kinds of ads work so well because poverty shrinks people’s attention. Urgent demands for an overdue utility bill or essential home repair can cause cash-strapped borrowers to focus on accessing quick and easy cash, neglecting fees and payments. interests that will come to them later.
In a series of recent studies, the subjects played a series of games. The “poor” subjects received fewer hits to win in each match, while the “rich” subjects received more hits. The researchers found that poor subjects focused more intensely on each shot and were more likely to take “loans” from additional plans – even if the loans depleted their savings for future games. As a result, poor subjects over-borrowed and earned less overall than rich subjects.
Surprisingly, all of these studies have been conducted on relatively well-off people, which means that any of us can make bad financial decisions when faced with financial insecurity.
Scientists are still working on the precise details of how poverty shapes economic decision-making, but the existing data is clear: Payday lenders target a population whose decision-making strategies are particularly vulnerable to exploitation. So how can we use this information to better protect consumers?
If stress causes borrowers to make deals they regret later, steps could be taken to prevent stressed clients from being exposed to tempting short-term loans. Recent work from our laboratory has shown that the most effective way to resist temptations is to avoid encountering them in the first place, as the will is often lacking. Regulations that make it more difficult for consumers to access expensive loans could function as a sort of collective “commitment device”.
Limit capacity for payday loan companies to advertise their services is a good first step; more robust approaches could include cap on borrowing costs Where prohibit companies from lending to those who cannot afford to repay.
If financial hardship narrows people’s attention to pressing cash flow issues and encourages them to overlook borrowing costs, policies that refocus attention on costs can help. The Fair Trade Office recently noted that payday lender advertisements tend to emphasize the speed and ease of access to loans, rather than interest rates – the same characteristics that make payday loans so dangerously attractive to people in financial difficulty.
At the very least, preventing payday lenders from displaying these characteristics in their advertisements, or forcing them to put more emphasis on borrowing costs, could in part mitigate the effects of poverty on borrowing decisions. . An even more effective approach would be to limit the tempting elements themselves, for example by impose a time limit before loan seekers can receive their money.
Archbishop Welby’s recent vow to offer competitive alternatives to companies like Wonga will fare much better if payday lenders are not allowed to advertise to sensitive populations and with an emphasis on the most attractive features of loans while hiding their costs. Lessons from psychology underscore the importance of smart regulation to prevent predatory businesses from targeting the most vulnerable parts of consumers’ brains.
National debt line (0808 808 4000; www.nationaldebtline.co.uk) offers free, confidential and independent advice on how to deal with debt issues