Though not a member of the banking committee, Sen. Richard Durbin, D-Ill., the Senate's majority whip, has become a significant force on financial services issues. Among other matters, he is championing a bill to establish a 36% annual cap nationwide on consumer credit fees and interest rates.
Though greater consumer protection is needed in some areas, the best of legislative intentions, which the senator undoubtedly has, can cause consumers to need protection from their protectors. The bill would stop creditors from offering many legitimate, fairly priced short-term credit products and remove billions of dollars in much needed credit.
Some lenders might think it inconceivable that Congress would even consider, let alone pass, such a proposal, especially given today's credit crisis.
However, given his prominence and political clout, and the fact that at least 100 consumer groups are strongly endorsing and pushing the bill, it should not be taken lightly.
To understand the problems with Durbin's proposal, and the apparent thinking behind it, one must understand the basic flaws in calculating annual percentage rates, or APRs, and in setting an across-the-board annual rate and fee cap.
Not all fees are required to be counted in the APR calculation, so equivalent credit products can have very different percentage rates, which leaves consumers confused and misled as to the true loan cost.
For example, consider the case of a federal credit union that offers a 30-day, $300 payday loan with interest of $4.50. It also charges but does not include in its APR calculation a loan fee of $35. If a traditional storefront payday lender offered the same loan for the same $39.50 cost, the APR would be 158%, compared to the credit union's 18% APR. Some costs, like overdraft fees, also generally do not have to be expressed in the APR. (If they did, as the FDIC has recently noted, APRs could be many times higher than, for example, that of a typical payday loan.)
When applied to short-term, small loans, APRs often present a very distorted and misleading picture of a loan's real cost. Annualizing such products' cost causes many to conclude erroneously that lenders are charging unreasonably high fees.
Here is how the confusion regarding annualized APRs arises. In simplified terms, the APR must be calculated by making the absolutely false assumption that the $15 fee for a two-week, $100 payday loan will be charged not simply the one time allowed by most state laws but for 25 additional two-week periods.
This annualized calculation adds the $15 real fee to the $375 in "make-believe" fees — that are not charged and normally are prohibited by state law — to come up with an inflated, "make-believe" cost of $390, or a 390% APR. This presents a distorted and misleading picture of the loan's actual cost.
The senator correctly recognized in his introductory comments that in many cases the APR does not convey accurate information. He proposes to correct this and would "level the playing field" by including basically all consumer credit costs in his 36% annual "Fair" (fees and interest rate) cap. Though helpful for disclosure, in the context of his rate cap, it would essentially "clear the field" of most credit options in the short-term, small-loan market because it costs more to make most smaller loans than lenders could charge.
For example, if the Durbin bill's 36% annualized cap is enacted, instead of charging $15 for a $100 loan, a payday lender could only charge $1.38, or a total of $4.14 for the average $300 loan. There simply is no way that such loans can be made because any lender's actual, reasonable costs of making the loan (for example, salaries, rent, underwriting, advertising, compliance, legal, etc.) are far above that figure. Lenders' costs vary, but the actual cost for major lenders of making such loans has been shown to be roughly $12 to $14 per $100 borrowed, so the lenders are not making exorbitant profits.
Even the credit union in the example above with a tax-exempt and nonprofit status could not break even on the loan if the bill's cap applied!
Though I am not advocating a national rate cap, if he is insistent on having one, Durbin should consider using a different approach with respect to smaller, shorter-term loans. Instead of annualizing rates and fees, he could devise a percentage limitation based on the total actual or maximum cost of a loan.
Thus, using the typical payday loan cost example noted above, a limitation might state that the total cost of the loan, including all interest and fees, could not exceed a certain percentage (say, 20% to 25%) of the loan's principal amount.
This alternative approach would provide better transparency than the current APR, making disclosures much easier for consumers to understand. And as long as the maximum percentage is set at a reasonable level, it would allow a broad range of credit options to be offered, while still barring extremely high-cost loans.
Not surprisingly, this workable approach is in effect used by most states to limit payday loan fees. For example, legislators in Durbin's home state of Illinois, who he surely is not suggesting have endorsed predatory rates, have enacted a state law limiting payday loan costs to $15.50, or 15.5% per $100 borrowed.
It may be difficult to imagine that in proposing his 36% annual cap on loan costs, the senator intended to prevent most current small-loan products from being offered.
Hopefully, he did not, but we should not necessarily assume so. He quite possibly has the view, as many advocacy groups apparently do, that key short-term credit options relied upon and needed now more than ever by tens of millions of people are simply too costly and should be prohibited.
If this is the case, he and his allies need to make a persuasive showing that there is a realistic way — which no one else has been able to find — to ensure that an adequate number of other affordable credit options will be available.