Limiting Interest Rates Without Limiting Access to Credit

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Setting caps on interest rates can lead to unintended, negative consequences for borrowers.

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Sir Isaac Newton famously postulated that for every action, there is an equal and opposite reaction. Although this principle is a cornerstone concept in physics, it is also quite applicable to the ongoing debate on Capitol Hill about federal interest rate caps on consumer loans.

Interest rate caps have received newfound attention from legislators seeking to moderate predatory lending practices within the small-dollar loan market. Proponents assert that these policies are necessary to protect vulnerable consumers from accepting usury loans—offered by payday lenders, pawnshop brokers, and other such outlets—that they cannot pay back, leading to “debt traps.”

Today, 18 states as well as Washington, D.C. have capped short-term loan rates to 36 percent or less, complementing federal interest rate limits that cover specific products and customers, such as the Military Lending Act (MLA), which applies to payday or installment loans to active-duty servicemembers. U.S. Senate Democrats introduced the Veterans and Consumers Fair Credit Act, which would build upon the MLA by setting a 36 percent federal interest rate cap applicable to all types of consumer loans.

Proponents of interest rate caps contend that such measures are vital for protecting consumer welfare, especially among low-income borrowers, but few acknowledge the significant, unintended consequences they engender for the very people they were meant to support.

The World Bank conducted a comprehensive review of six types of interest rate caps and that found these policies to have major adverse consequences for consumers, including increased non-interest fees or commissions, reduced price transparency, in addition to lower credit supply and loan approval rates primarily affecting small and risky borrowers.

The World Bank study also noted equally unfavorable effects for the financial ecosystem, including decreases in the number of institutions and reduced branch density stemming from lower profitability—effects which were particularly acute for small institutions focused on providing traditional depository or lending services, compared to large multinational conglomerates such as investment banks.

These findings have been echoed within similar analyses of small-dollar loan markets in the United States. A study by the Federal Reserve and George Washington University found that financial institutions within states with lower rate caps offered fewer small-dollar loans, most of which were completely inaccessible to low-income borrowers since their lending risk could not be accurately priced under the terms of state-mandated interest rate limits.

Another study conducted by the Consumer Financial Protection Bureau’s Taskforce on Federal Consumer Finance Law determined that arbitrary limits on interest rates would “undoubtedly” put lenders out of business and prevent middle-class and struggling Americans from accessing affordable credit, concluding such policies should be eliminated entirely.

Unfortunately, these analyses affirm an elementary economics principle—price caps, or ceilings, create shortages.

In practical terms, when prices are forced to remain artificially below a market equilibrium, demand for such goods and services—such as low-interest loans—increases beyond what producers—such as financial institutions—are able or willing to supply.

Interest rates are not simply an opportunity for financial institutions to take their pound of flesh. Rather, they are an estimate of market conditions, profit margins, and default risk. This last consideration is particularly important when considering the profile of a typical consumer for whom interest rate caps were meant to benefit: low-income borrowers with a high risk of default.

Even though interest rate caps would certainly expand eligibility, and thereby demand, for small-dollar consumer loans, their failure to assuage legitimate concerns of default risk would push financial institutions to simply restrict their services to the most qualified borrowers.

This shortage is a real possibility under the Veterans and Consumers Fair Credit Act, which would limit the interest rate on all consumer loans using a commonly cited benchmark known as an annual percentage rate (APR) of 36 percent. APRs can inflate the true cost of a small-dollar loan, comprising operational costs, default protection costs, and delinquency management costs borne by the financial institution.

According to a study by the Financial Health Network, at a 36 percent APR, a financial institution would break even if the value of the loan were at least $2,600 and profit if its value were around $4,000. Therefore, a 36 percent APR would virtually eliminate any such profit margins for smaller loans of $500 or $1,000, which would force financial institutions to operate at a loss and could lead to greater pressure on consumers to borrow more than they need. In turn, this pressure could lead to higher finance charges and longer repayment periods despite lower interest rates.

Providing consumers of all socioeconomic backgrounds with access to affordable credit is a laudable objective, but dependence on interest rate caps, such as a 36 percent APR that would be instituted under the Veterans and Consumers Fair Credit Act, will probably induce an equal and opposite reaction that fails the very low-income borrowers for whom such policies were meant to support.

Policymakers could use other initiatives to limit rates without limiting access to credit:

  • Promote price transparency. Research suggests that borrowers understand fee disclosures more than APRs, therefore ensuring borrowers are aware of all fees on a given loan rather than its APR could potentially decrease unnecessary borrowing.
  • Encourage longer repayment terms. Anecdotal evidence from an FDIC-sponsored pilot program into small-dollar consumer lending found that extending loan terms to 90 days would enable borrowers to bolster savings and acquire new financial management skills.
  • Restrict repeat-borrowing. Some states have begun to limit the total number of loans with high interest rates provided to a single borrower within a fixed period of time, thereby reducing the possibility for low-income customers to fall into debt traps.
  • Encourage emergency savings. Some lenders require initial deposits into a savings account prior to approving a short-term loan, and state or federal level initiatives could provide incentives for lenders to include these terms to help their borrowers develop long-term emergency savings.

Although less ubiquitous and more nuanced than interest rate caps, these solutions would offer policymakers a better chance of fostering sustainable, market-driven changes in the small-dollar lending market, where ample access to low interest rate loans is a reality for all consumers.

Noah Yosif

Noah Yosif is assistant vice president of economic policy and research for the Independent Community Bankers of America.