As the credit crisis has worsened, we no longer hear the argument once commonly made in support of subprime mortgages, namely, that they were good for people with poor credit, since it enabled them to buy housing they could not otherwise afford Maybe it’s because the problems we are seeing resulted from the fact that subprime loans did enable people to buy housing they couldn’t afford.
The call for more regulation of mortgage lending has also increased interest in the broader question of other limitations on forms of consumer credit that critics see as predatory, such as payday loans (annualized interest rates of 390%) and credit cards. In the topsy-turvy world of revolving credit, people who pay off their accounts in full every month are “deadbeats” since the banks don’t make much in the way of profits on them, while low income customers who are constantly in debt are one of their most profitable segments.
Aside from the value of access to credit, another argument made in favor of costly financing to the poor is that without access to legitimate sources of lending, poor people would turn to worse sources.
In a recent paper, Angela Littwin of Harvard Law School (hat tip Credit Slips) investigates how low-income consumers use credit cards relative to other borrowing sources. She conducted 50 in-depth interviews of low income consumers. While this may seem like a small sample, (Littwin provides the usual caveats) corporations seldom conduct such extensive in person research:
One of the strongest arguments against regulating credit cards is the substitution hypothesis, which states that if a restriction on credit cards decreases access, borrowers will respond by using other, less desirable forms of credit. For low-income consumers, the argument is more powerful still, because their other options are high-cost lenders such as pawn shops and rent-to-own stores. But the substitution hypothesis has been more frequently assumed than investigated, and the empirical research that has taken place does not support the theory as strongly as has been supposed. This Article presents original data from a study of low-income women. The findings suggest that lenders such as pawn shops and rent-to-own stores may function as complements more than substitutes. More critically, low-income borrowers may experience credit cards as no more desirable than these other borrowing types. In addition, the research uncovered another form of credit that low-income families routinely use and participants evaluated favorably, but that is never discussed in literature.
The other funding source was friends and family, and was used by more of the survey respondents than credit cards.
Littwin points out that prior analyses have erred in treating other credit products, like pawn shops, as perfect substitutes for credit cards, when they are in fact only partial substitutes. Thus researchers have failed to ascertain to what degree substation actually occurs. Moreover, she argues that a negative element of credit cards, that they act as spending stimuli, is not acknowledged in many studies. Yet the fact that many vendors (think car rental companies) require the use of a credit card, and their role as an indicator of middle class status, makes it hard for the poor to turn them down. In another paper, she noted:
Most academics, particularly economists, seem to think that all credit card features are a matter of nothing more than interest rates and fees. In some macro sense that may be true, but for card users themselves, the central issues are less about those specific cost items and more about the way credit cards influence their spending and borrowing patterns. The credit card problem participants cited most frequently was temptation. Nearly two-thirds described credit cards as tempting or enticing, whereas only 42 percent argued for a reduction in interest rates. Participants felt enticed to apply for credit cards against their better judgment, and once they had them, they found it undesirably easy to spend money they did not have….
An explanation for high credit card spending that has significant support in the empirical literature is hyperbolic discounting or, more generally, present-biased preferences. These terms refer to the finding that people tend to be poor predictors of their own future preferences. Specifically, we habitually underestimate the intensity of our reactions to future costs and benefits.62 In economic terms, a hyperbolic discounter applies larger discount rate to events that will take place in the near future and a smaller discount rate to events that seem further off.
Of course, any card features that reduced temptation would also reduce income to the issuer.
Most damning to credit card advocates, survey participants regarded credit cards as on a par with other sources of credit that the middle classes generally shun.:
My preliminary evidence casts doubt on the conception that borrowing from credit cards is somehow “better” than borrowing from fringe-banking alternatives.202 Participants evaluated credit cards approximately equally with rent-to-own stores and less highly than pawn shops and catalogs{lenders].
Or as Credit Slips more pointedly observed:
….according to the families she studied, there were no credit options worse than credit cards. In other words, in the words of these struggling families, credit cards are as bad as it gets.
