Limit interest rates without limiting access to credit

Setting limits on interest rates can have unintended negative consequences for borrowers.

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 also applies very well to the ongoing debate in Capitol Hill over federal interest rate caps on consumer loans.

Interest rate caps have received a whole new attention from lawmakers seeking to moderate predatory lending practices in the small loan market. Proponents say these policies are necessary to protect vulnerable consumers from accepting usury loans – offered by payday lenders, pawn shops and other outlets – that they cannot pay back, which leads to “debt traps”.

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

Advocates of interest rate caps argue that such measures are vital to protect the well-being of consumers, especially among low-income borrowers, but few recognize the significant and unintended consequences for the people themselves. that they were supposed to support.

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

The World Bank study also noted equally unfavorable effects for the financial ecosystem, including a decrease in the number of institutions and a reduction in the density of branches resulting in lower profitability – effects that were particularly significant. acute for small institutions focused on providing traditional deposit or lending services, compared to large institutions in multinational conglomerates such as investment banks.

These findings have echoed in similar analyzes of the small loan markets in the United States. A study by the Federal Reserve and George Washington University found that state financial institutions with lower cap rates offered fewer low-value loans, most of which were completely inaccessible to low-income borrowers because of their lending risk. could not be accurately assessed under the conditions. interest rate limits imposed by the state.

Another study by the Consumer Financial Protection Bureau’s Federal Consumer Finance Act task force determined that arbitrary limits on interest rates would “definitely” put lenders out of business and keep Americans out of business. middle class and struggling to access affordable credit, concluding that such policies should be scrapped. entirely.

Unfortunately, these analyzes affirm a principle of elementary economy: ceiling prices, or ceilings, create shortages.

Concretely, when prices are forced to remain artificially below market equilibrium, the demand for these goods and services, such as low-interest loans, increases beyond what producers, such as financial institutions, are able or willing to provide.

Interest rates are not just an opportunity for financial institutions to take their pound of flesh. Rather, it is 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 supposed to benefit: low-income borrowers with a high risk of default.

While interest rate caps would certainly increase eligibility, and therefore demand, for low-value consumer loans, their failure to allay legitimate fears of default risk 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 would limit the interest rate on all consumer loans using a commonly cited benchmark known as the credit rate. annual percentage (APR) of 36%. APRs can inflate the actual cost of a small loan, including operational costs, default protection costs, and delinquency management costs borne by the financial institution.

According to a Financial Health Network study, at an APR of 36%, a financial institution would break even if the value of the loan was at least $ 2,600 and make a profit if its value was around $ 4,000 . Therefore, an APR of 36% would eliminate virtually all of those profit margins for small loans of $ 500 or $ 1,000, forcing financial institutions to operate at a loss and could put more pressure on consumers to do so. they 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 from 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 imposed under the Act on fair credit for veterans and consumers, will likely elicit an equal and opposite reaction. this fails the very low income borrowers for whom such policies were supposed 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 better than APRs, so ensuring borrowers are aware of all charges on a given loan rather than its APR could potentially reduce unnecessary borrowing.
  • Encourage longer repayment terms. Anecdotal evidence from an FDIC-sponsored pilot program on small dollar consumer loans found that extending loan terms to 90 days would allow borrowers to strengthen their savings and learn new skills in financial management.
  • Restrict repeated borrowing. Some states have started to limit the total number of high-interest loans made to a single borrower within a specified time frame, reducing the possibility for low-income clients to fall into the debt trap.
  • Encourage emergency savings. Some lenders require initial deposits to a savings account before approving a short-term loan, and initiatives at the state or federal level could encourage lenders to include these conditions to help their borrowers develop emergency savings. long term.

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

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

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