Limit interest rates without limiting access to credit

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

Interest rate caps have has received new attention from lawmakers seeking to curb predatory lending practices in the small loan market. Promoters to assert that these policies are necessary to protect vulnerable consumers from accepting loan sharking – offered by payday lenders, pawnbrokers and other similar outlets – that they cannot repay, resulting in “debt traps.”

Today, 18 states plus Washington, DC have capped short-term lending rates at 36% or less, supplementing federal interest rate limits that cover specific products and customers, such as Military Loans Act (MLA), which applies to payday or installment loans to active duty military personnel. US Senate Democrats introduced the Fair Credit Act for Veterans and Consumerswhich would rely on the MLA in setting a federal interest rate cap of 36% applicable to all types of consumer loans.

Proponents of interest rate caps argue that these measures are essential to protect consumer welfare, particularly among low-income borrowers, but few recognize the significant and unintended consequences they create for the very people who were meant to help.

the world Bank conducted a thorough investigation review of six types of interest rate caps and found that these policies had major negative consequences for consumers, including increased non-interest charges or fees, reduced price transparency, in addition to decline in credit supply and loan approval rates mainly affecting small, risky borrowers.

The World Bank study also Noted equally adverse effects for the financial ecosystem, including a decrease in the number of institutions and a reduction in branch density resulting from lower profitability – particularly acute effects for small institutions focused on providing depository services or traditional lending companies, compared to large multinational conglomerates such as investment banks.

These findings have been echoed in similar analyzes of small loan markets in the United States. A study by the Federal Reserve and george washington university find that financial institutions in states with lower rate caps were offering fewer small loans, most of which were completely inaccessible to low-income borrowers since their lending risk could not be accurately assessed within the limits of interest rates imposed by the state.

Another one to study led by the Consumer Financial Protection Bureau Federal Consumer Finance Act Task Force determined that arbitrary limits on interest rates would “undoubtedly” bankrupt lenders and prevent middle-class and struggling Americans from accessing affordable credit, final these policies should be eliminated entirely.

Unfortunately, these analyzes affirm a basic economic principle – price caps, or caps, to create shortages.

Specifically, when prices are strength To stay artificially below a market equilibrium, demand for these goods and services – such as low-interest loans – increases beyond what producers – such as financial institutions – are capable of or willing to provide.

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

While interest rate ceilings would certainly broaden the eligibility, and therefore the demand, for small consumer loans, their failure to allay legitimate default risk concerns would cause financial institutions to simply restrict their services to the most qualified borrowers.

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

According to a Financial Health Network study, at an APR of 36%, a financial institution break even if the value of the loan was at least $2,600 and profit if its value was around $4,000. Therefore, an APR of 36% would virtually eliminate these profit margins for small 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 result in higher finance charges and longer repayment periods despite lower interest rates.

Providing consumers of all socio-economic backgrounds with access to affordable credit is a laudable goal, but reliance on interest rate caps, such as a 36% APR that would be instituted under the Act on fair credit for veterans and consumers, will likely elicit an equal and opposite reaction. which fails the very low-income borrowers for whom these policies were meant to support.

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

• Promote price transparency. To research suggests that borrowers understand fee information better than APRs, so ensuring borrowers are aware of all fees on a given loan rather than its APR could potentially reduce unnecessary borrowing.
• Encourage longer repayment terms. Anecdotal evidence of an FDIC-sponsored small dollar consumer loan pilot program find extending loan terms to 90 days would allow borrowers to strengthen their savings and learn new money management skills.
• Restrict repeat borrowing. Some states have begin at limit the total number of high-interest loans issued to a single borrower over a specified period of time, thereby reducing the possibility of low-income clients falling into debt traps.
• Encourage emergency savings. Some lenders require initial deposits in a savings account before a short-term loan is approved, and initiatives at the state or federal level could encourage lenders to include these conditions to help their borrowers build savings long-term emergency.

While less pervasive and more nuanced than interest rate caps, these solutions would offer policymakers a better chance of fostering lasting, market-driven changes in the low-interest loan market, where broad access to low interest loans is a reality for all consumers.