Freedom to Borrow

Imposing interest rate caps on loans and restricting the credit options available to consumers are ill-conceived policies that do not achieve their desired outcome. Such policies unfairly target short-term, small-dollar loans that many disenfranchised and disadvantaged people use. People with subprime credit scores or “underbanked” or “unbanked” people often rely on these types of loans and other creative financing solutions to access credit for car repairs, to pay rent, or in a medical emergency.

What Are Short-Term, Small-Dollar Loans?

A short-term, small-dollar loan is a loan ranging from $50 to $1,000 with the average being $375. Borrowers pay back the loan in full, plus the interest rate, usually within 14 days.

These types of loans are usually taken out by individuals who are short on cash and need money for an expense before their next paycheck—individuals who, without this credit, would otherwise be unable to afford an unexpected expense. Three in ten Americans lack the savings to cover an emergency expense of $400. Some examples: a necessary car repair, a medical emergency, or a security deposit on a new apartment.

Below are some examples of short-term, small-dollar loans:

• A payday loan is usually a short-term loan, generally for $500 or less, that is typically due on the borrower’s next payday or when regular income is received from another source. The loans are for small amounts, and many states set a limit on payday loan size ($500 is a common loan limit, though there is a range). To repay the loan, the borrower generally provides authorization for the lender to transfer electronically the full balance, including fees, from a bank, credit union, or prepaid card account. Thus, it is a balloon payment loan, similar in term and requirements to an overdraft check “loan.” An advantage of a payday loan is that it can serve as a bridge between bill due date and payday and can ensure less costly consequences than an overdraft or utility shut-off.

• Consumers often use unsecured consumer installment loans, also known as signature loans, loans of good faith, or personal loans to manage variable expenses, to pay down higher-interest debt, or to finance a special purchase. One advantage of using an unsecured consumer installment loan is that it can help someone with little or no credit history to establish a credit rating.

• Small-dollar consumer loans typically have shorter terms, lower balances, and below-average credit characteristics. They can be viewed as an alternative to other forms of lending, such as payday lending, and, according to the U.S. Department of Treasury, they serve a niche of consumers that may not have many alternatives. The demand for short-term, small-dollar products is high, because many households struggle with income volatility, thin or nonexistent credit files or a subprime score, or lack of access to mainstream financial products that meet their needs. An advantage of small-dollar consumer loans is that they allow consumers to break down large costs and divide their outflows of cash into even, predictable amounts.

Who Uses Short-Term, Small-Dollar Loans?

• A young person with insufficient credit history to qualify for a traditional credit product.

• An otherwise creditworthy consumer with a sudden destabilizing financial experience.

• A recent immigrant who lacks a credit history.

• A person who has a history of being irresponsible with credit and who is thus unlikely to be approved for traditional  credit products.

What are Rate Caps and Why are They Bad for Consumers?

An interest rate cap is a limit on how high an interest rate can rise, and thus how much a financial institution can charge a borrower for borrowing the money. At first glance, this seems like a consumer-friendly policy. However, a rate cap restricts access to credit for those who lack access to traditional financial institutions. Interest rate caps also limits the amount of options a consumer has at their disposal.

A rate cap at any level would result in the erosion of the freedom to borrow.

Many disadvantaged people have no bank account or face tenuous financial circumstances. They often rely on a safety net of innovative alternative, short-term forms of credit, which sometimes carry higher interest rates. Instituting a rate cap could run the risk of excluding many individuals from the credit community and completely “unbanking” them.

Short-term, higher-cost, and single-payment loans can be an affordable and attractive form of credit for many Americans whose credit scores are sub-prime. Such loans are also superior to desperate alternatives like bouncing a check, bankruptcy, or piling up debt on a credit card and paying only the monthly minimum, or worse.  

Why is 36% Used in Interest Rate Caps so Often?

Where did the 36 percent number come from? Consumer advocate Arthur Ham wrote The Chattel Loan Business over a century ago, in 1909, and found by trial and error that he could attract investors to make loans at 3.5 percent per month for loans up to $100 and at 2.5 percent per month for loans above $100. The average of 2.5 and 3.5 is 3.0, and the 36 percent annual interest rate was born. An important fact to note: Unlike current proposals to impose a 36 percent rate cap, Ham’s 36 percent annual interest rate was not an APR as people know them today; with his rate, he allowed for the addition of fees and ancillary product charges.

Also, it is important to note: The 36 percent rate cap is not rooted in economic reality or necessity. Indeed, the Center for Financial Services Innovation (CFSI) notes, “Concerns about the charging of interest and the amount of interest being charged have deep religious, cultural, and legal roots.”

Moreover, the math simply does not work: A 36 percent rate cap does not allow a margin of profit. Consequently, where a 36 percent rate cap is implemented, credit deserts appear.

Today, what is called “interest” for purposes of a 36 percent rate cap includes items that Ham would not have included, such as fees charged to cover the cost of doing business—paying employees, the cost of capital, and the cost of bad debts, for example. A $15 fee on a $100 loan returns a $1.11 pretax profit; a 36 percent interest rate on the same loan results in a loss of $12.51.

The practical result of a 36 percent cap—the creation of credit “deserts”—stands in opposition to the overwhelming agreement among voters that everyone has a right to access credit.

Some states have passed interest rate caps through the initiative process. The unfortunate situation is that most voters do not understand the math behind interest rates, and a 36 percent cap sounds good superficially. People pushing ballot initiatives do not bear the burden of transparency, because initiatives are ultimately political exercises, not educational ones. If voters were fully informed, they likely would not vote to ban subprime borrowers from having access to credit.

Equally unfortunate in some states, legislatures and governors have passed interest rate caps under similarly naive but well-meaning circumstances.

In either case, the bottom line is that interest rate caps exist in several regressive, non-innovative states.

Illinois provides an excellent lesson on the negative effects of interest rate caps on consumers.

The Lesson from Illinois

On March 23, 2021, Illinois imposed an all-in interest-rate cap of 36 percent per annum for loans under $40,000 from non-bank and non-credit-union lenders.

In a study entitled “Effects of Illinois’ 36 percent Interest Rate Cap on Small-Dollar Credit Availability and Financial Well-being,” J. Brandon Bolen of Mississippi College, Gregory Elliehausen of the Board of Governors of the Federal Reserve System, and Thomas Miller of Mississippi State University found that “the interest-rate cap decreased the number of loans to subprime borrowers by 44 percent and increased the average loan size to subprime borrowers by 40 percent” and that the financial well-being of borrowers, particular subprime borrowers, worsened.  

The researchers examined the welfare effects of the loss of credit access using an online survey of short-term, small-dollar-credit borrowers in Illinois. Most borrowers answered that they were unable to borrow money when they needed it in the nine months following the imposition of the interest-rate cap.

The people who were unable to obtain a loan reported that they paid bills late and incurred late fees, that they had to borrow from family or friends, that they fell into debt collection, and that they were forced to pawn personal possessions, etc.  

The study found that indebtedness increased after imposition of the 36 percent interest-rate cap: Average loan sizes increased by 12 percent for prime borrowers, 25 percent for near-prime borrowers, and 31 percent for subprime borrowers.

At the same time, the study also found that Banks and Credit Unions barely increased the number of small-dollar loans to high-risk borrowers in the six months after the rate cap was imposed compared to the six months prior while other lenders decreased the same loans massively, showing how much the availability of credit to subprime borrowers contracted as a result. Indeed, overall, there were 45 percent fewer loans originated for subprime borrowers.  

Only 11 percent of the study’s survey respondents answered that their financial well-being increased following the interest-rate cap, and 79 percent answered that they wanted the option to return to their previous lender. 

Thus, the Illinois interest-rate cap of 36 percent significantly decreased the availability of small-dollar credit, particularly to subprime borrowers, and worsened the financial well-being of many consumers.

More information

"Effects of Illinois' 36% Interest Rate Cap on Small-Dollar Credit Availability and Financial Well-being," https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4315919

This study uses a consumer survey and finds that a 36% interest rate cap imposed in Illinois in 2021 significantly decreased the availability of small-dollar credit, particularly to subprime borrowers, and worsened the financial well-being of many consumers.

“Price Regulation in Credit Markets: A Trade-off between Consumer Protection and Credit Access,” https://economics.yale.edu/sites/default/files/jmp_jicuesta.pdf

This study shows that when interest rates were forced lower, the number of loans also decreased.

“Why The Loan Shark Prevention Act Will Harm Consumers,” https://www.pymnts.com/economy/2019/sanders-ocasio-cortez-credit-card-interest-rate-caps-loan-shark-prevention-act/

This article explains how desperate consumers who are supposed to be helped by the Loan Shark Prevention Act will very likely, and ironically, be pushed into pushed into the world of loan sharks and pawn shops and illegal lending.

“Interest Rate Caps: The Theory and the Practice,” http://documents.worldbank.org/curated/en/244551522770775674/pdf/WPS8398.pdf

This study shows that the unintended side-effects of interest rate caps can include increases in non-interest fees and commissions, reduced price transparency, lower credit supply and loan approval rates for small and risky borrowers, and a lower number of institutions and reduced branch density.

“The Impact of the U.S. Debit Card Interchange Fee Caps on Consumer Welfare: An Event Study Analysis,” https://chicagounbound.uchicago.edu/cgi/viewcontent.cgi?article=1651&context=law_and_economics

This study shows that consumers lost more on the bank side than they gained on the merchant side as a result of the Durbin Amendment to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

“A Business and Financial Review by the Federal Reserve Bank of Chicago, Midyear 1982,” https://fraser.stlouisfed.org/title/5288/item/552426

Part of this report shows the negative impact on borrowers of usury ceilings, which take away certain credit products from the market choices that borrowers otherwise would have had.

“Impact of the US Housing Crisis on the Racial Wealth Gap Across Generations,” https://s3.amazonaws.com/ssrc-cdn1/crmuploads/new_publication_3/impact-of-the-us-housing-crisis-on-the-racial-wealth-gap-across-generations.pdf

This presentation highlights long-term racial disparities that arise in economic downturns and recommends opening access to credit to help alleviate these disparities.