Consumer Credit and the American Economy by Thomas A. Durkin

Author:Thomas A. Durkin [Durkin, Thomas A.]
Language: eng
Format: epub
Publisher: Oxford University Press
Published: 0101-01-01T00:00:00+00:00

The second panel of table 8.1 summarizes the cash flows and calculates the net present value of using a payday loan to pay for the repair. The cost of the repair C is the net cash flow on day 0. The cost of public transportation is the periodic savings, St, which are $4.56 per day on weekdays and $0.00 on weekends. In addition, the consumer incurs the cost of repairing the automobile at the end of two weeks.

The column on the right provides the discounted value of the cash flow. The periodic discount rate is 1.07 percent per day, which is the finance charge of $15 per $100 borrowed divided by the 14 days (the term of the payday loan). The net present value is the sum of discounted cash flows $14.55. The positive net present value indicates that borrowing at 1.07 percent per day, a 309.00 percent annual percentage rate, leaves the consumer with greater wealth than waiting and using public transportation.

It is worth noting that the undiscounted net value of using the payday loan equals the $45.60 sum of net cash flows from the table minus the $30 finance charge for the payday loan or $15.60. That result, $15.60, is not much different from the $14.55 discounted net present value. Despite the high discount rate, the effect of discounting is small because of the very short term to maturity. The short term to maturity for many of the high-price credit products simplifies the consumer’s decision. There is not any great need to think in terms of discounting cash flows, even in theory, because the time is so short that the undiscounted cost serves as a good proxy for the discounted costs, even if the discount rate is very high. This would not be the case for a long-term loan, of course. Extended use of this sort of credit is where it becomes most highly controversial.

This example is obviously hypothetical. Different assumptions might lead to different decisions. A more costly repair or daily parking fees would reduce net present value and might produce negative net present values. Additional trips using public transportation or a higher opportunity cost rate would increase net present value and might produce a positive net present value even for a more costly repair or including daily parking fees. Data that permit calculation of net present values for actual payday loan decisions are not available. Nevertheless, the example illustrates that there are plausible situations in which use of high-price credit is rational.

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