Understanding how people get sucked into these debt traps is an important public-policy

issue, according to Northwestern’s Dean Karlan, Chicago Booth’s Sendhil Mullainathan,

Given an out, peoplestill fall back into debtResearch finds that keeping people out of debt traps isn’t as simple aspaying off their loans

Credit: Associated Press

DEE GILL | JAN 14, 2019

SECTIONS FINANCE PUBLIC POLICY

T o the frustration of financial counselors everywhere, millions of people doom

themselves to perpetual debt by repeatedly taking out small but expensive

short-term loans they can barely afford. In the United States, these typically

come from payday or car title lenders and go to financially strapped

individuals. In developing countries, small-scale entrepreneurs rely on daily or weekly loans

for working capital. In both cases, borrowers pay exorbitant interest rates and, often,

additional fees to extend a loan over and over. Interest payments can quickly add up to

more than the loan amount. 

and Harvard’s Benjamin N. Roth. They conducted a series of experiments with indebted

entrepreneurs in India and the Philippines and find that having their short-term loans paid

off took the participants out of debt only temporarily. The entrepreneurs in question quickly

took out new, profit-sapping loans.

In these experiments, completed in 2007 and 2010, the researchers provided brief financial

training to market vendors who had high-interest debt. The Indian entrepreneurs were

paying average monthly rates of 432 percent, while the Philippine borrowers averaged 13

percent in monthly interest costs, according to the study. By comparison, annual rates on

payday loans in the US range from about 390 to 780 percent (according to the nonprofit

Consumer Federation of America). The training delivered the message that borrowing from

moneylenders was far more expensive than alternatives such as reducing consumption.

The researchers then paid off the moneylender debts of some of the participants—in India,

the reduced interest was equivalent to doubling their income. The remaining participants

served as a control group. Participants completed four follow-up surveys between a month

and two years after the repayments.

Within two years, debt levels for the vendors whose debts had been paid off rose back to the

level of the control group, the researchers find. Most vendors fell back into debt within six

weeks, even though some of them generated considerably higher profits after the

repayment because their profits weren’t being eaten up by interest payments.

Financial training may have only delayed the entrepreneurs from returning to lenders,

according to the researchers. Across the board, debt relief did not affect spending habits.

The entrepreneurs with paid-off loans were no more likely to have savings after two years

than the others, Karlan, Mullainathan, and Roth report. 

Poverty and scarcity affect decision making, other research finds. (See “How poverty

changes your mind-set,” Spring 2018.) Understanding the reasons behind such continued

borrowing is important for policy makers in addressing predatory lending, including high-

interest loans offered to small-scale entrepreneurs. Restrictions on such lending would not

make sense, for example, if the loans helped vendors to significantly increase their

earnings, the researchers write. In addition, if these loans save borrowers from destitution

because of unexpected bills or wage losses, improving social services might be more

helpful than outlawing lending. 

Karlan et al., 2018

Some high-interest debt appeared to be

justified, such as when vendors were able to

increase profits by investing the borrowed

money in their businesses, the study finds.

However, if vendors were going to be wise

about the debt, they would have used the

new profits to get debt-free again, which

they didn’t do. 

Some appeared to stay maxed out on

expensive loans because they were

repeatedly hit with financial shocks. In that

case, the research indicates, making a one-

time payoff simply enabled more borrowing.

Karlan, Mullainathan, and Roth suggest that

a better understanding of how vendors

spend borrowed funds is needed to craft

policies that might prevent these debt

cycles.

© 2019 CHICAGO BOOTH REVIEW. ALL RIGHTS RESERVED

WORKS CITED

Dean Karlan, Sendhil Mullainathan, and Benjamin N. Roth, “Debt Traps? Market Vendors andMoneylender Debt in India and the Philippines,” Working paper, April 2018. 

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