Why a 36% Cap Is Too Low for Small-Dollar Loans
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The Obama administration recently announced new regulations that expand the Military Lending Act of 2006. The MLA caps payday loans to military personnel at a 36% annual percentage rate. Why do we trust our volunteers in the armed forces to make life or death decisions, but ban them from making a financial decision to pay the typical $60 cost of a two-week, $300 payday loan?
With or without payday lenders, the demand for short-term credit will still exist. Moreover, illegal lenders will gleefully supply $300 short-term loans. They typically charge $60 interest for one week, not for two weeks.
The MLA effectively bans payday lending to military personnel. A two-week $300 payday loan with a 36% APR would generate $4.15 of interest income. This cost to the consumer is about equal to the average cost of an out-of-network ATM charge. An ATM withdrawal is riskless, but a payday lender faces production costs, including default risk, that greatly exceed $4.15. Therefore, payday lenders will not make loans capped at 36% APR.
The new regulations will extend the 36% rate cap to additional types of small-dollar loans made to military personnel, including installment loans. Unlike payday loans, installment loans are paid back in equal installments, and the amount owed decreases over time. These new regulations limiting interest rates are the latest in a long series of misguided legislation and regulations that limit or deny access to important consumer credit products. Interest rate caps, like other price controls, have severe unintended consequences.
Is a 36% annual interest rate for a small-dollar loan too high? Those who say "yes" likely have a worldview shaped by large-dollar home mortgages or auto loans. But people need to borrow money for many reasons. Millions of Americans rely on nonbank-supplied small-dollar loans to meet wide-ranging credit demands like durable goods purchases or for unexpected automobile repairs.
The National Consumer Law Center claims a 36% annual interest rate cap is validated by a "long and well-recognized history in America dating back 100 years." As Lone Ranger fans have often heard, please "return with us now to those thrilling days of yesteryear."
In the Progressive Era of the early 20th century, credit reformers understood that the needs of borrowers and lenders had to be satisfied to create a sustainable market-based alternative to illegal "loan sharks." These reformers sought to pass state laws allowing licensed lenders to make small-dollar loans at rates above state-imposed interest rate ceilings, then typically 6%.
In partnership with lenders willing to risk capital by making loans repaid in equal installment payments, reformers framed the model Uniform Small Loan Law of 1916. Through rigorous studies, the reformers determined that the costs and risks of small-dollar lending merited an annual interest rate of about 36%. In 1916, $300 or less was deemed a small-dollar loan ($6,900 in 2015 dollars).
Small-dollar installment loans remain an important nonbank-supplied consumer credit product. Installment lenders carefully identify potential borrowers who will be able to repay the loan. Only about half the people seeking an installment loan get one. Those denied must find another credit source.
During a recent state legislators' conference, this question arose: "Why can't installment lenders make money at a 36% APR?" They can if the dollar amount borrowed is large enough to generate enough interest income to cover the costs and risks of making the loan. A $300, 12-month, 36% APR installment loan generates $61.66 in interest income. Why were $300 installment loans profitable in 1916, but not in 2015? Although the interest income is the same, the loan production costs, including wages, benefits, rent, and utilities have dramatically increased over time. The consumer price index is about 20 times higher in 2015 than it was in 1916.
The Uniform Small Loan Law of 1916 states that a rate established by legislators "should be reconsidered after a reasonable period of experience with it." Clearly, the succeeding 100 years exceeds "a reasonable period." Today, a $300 installment loan is simply not profitable at a 36% interest rate. Neither are payday loans. The result is that a legal loan desert exists in the small-dollar loan landscape. There is demand, but no supply.
Consumer advocates, regulators, and legislators must stand courageously and do what the far-sighted reformers did 100 years ago: allow for much higher interest rates on small-dollar loans. The cost to consumers is low. A 108% APR on a $300, 12-month installment loan costs only $2.94 per week more than a similar loan at a 36% APR. Consumers should have the choice to pay this additional pittance. The trifling amount can help eliminate the loan desert.
Thomas W. Miller Jr. is a professor of finance, Jack R. Lee Chair in Financial Institutions and Consumer Finance at Mississippi State University and a visiting scholar with the Mercatus Center at George Mason University. Chad Reese is the assistant director of outreach for financial policy at the Mercatus Center. Mercatus Center research assistant Vera Soliman and Carolyn Moore Miller contributed to this piece. The views and opinions expressed herein do not necessarily reflect those of Mississippi State University.