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The Economic Illiteracy of a 36 Percent Interest Rate Cap

Earlier this week, the House Financial Services Committee held a hearing on a draft bill that proposes to set a national 36 percent annual percentage rate (APR) cap. That is to say, for daring to provide credit to people who would otherwise be unable to access it—something considered to be Nobel Prize-worthy in other parts of the world—you could face up to one year in prison and a $50,000 fine for each violation.

The legislation would destroy large swaths of the country’s consumer credit market, especially for those living on the financial fringe. As any economics 101 class would teach you, setting a price ceiling below the market clearing rate will create a shortage. By doing so, a 36 percent rate cap will solve precisely none of the concerns that motivated the legislation, such as improving the financial well-being of the poorest Americans.

Central to the argument for a 36 percent interest rate cap is the idea that high-priced credit, such as payday, installment, and vehicle title loans as well as bank overdraft fees, are “predatory.” But headline grabbing numbers of “400 percent APR” and “huge profits” for small-dollar lenders are deceptive, at best.

As my colleague John Berlau made clear in his paper, “The 400 Percent Loan, the $36,000 Hotel Room, and the Unicorn,” the annual percentage rate of interest is inappropriate for small-dollar loans, because they are not used on an annual basis. A 400 percent APR on a two-week loan may sound enormous, but in reality it equates to a little over $15 of interest for $100 borrowed, or 15 percent. As the acclaimed economist Thomas Sowell pointed out, using this same reasoning of pricing short-term products on an annual basis means that a hotel room should be advertised as upwards of $36,000.

It is also important to note that what is called “interest” includes things like fees charged to cover the cost of doing business—not something that is typically considered to be part of an APR in a credit card or mortgage agreement. For example, what if ATM fees were calculated in the same way? A $3 fee on a $50 withdrawal, in certain circumstances, is equivalent to a 730 APR loan. But we do not think of it in the same way, and for good reason.

A relatively high-interest rate for small dollars loans makes sense for a number of reasons. First of all, due to the fixed costs of running any business—including the costs of operating a storefront, paying employees, the cost of capital, and the cost of bad debts—lenders must charge a price that enables them to turn a profit. As seen in the chart below, a $15 fee on a $100 loan turns $1.11 of pretax profit. On the other hand, a 36 percent interest rate on the same loan results in a loss of $12.51.

Cost of a payday loan, with and without a 36 percent interest rate cap

 

With a fee of $15 per $100

With a 36 percent rate cap

Revenue, per $100 loan:

$15.00

$1.38

Costs per $100 loan

 

 

Operating expenses:

$9.41

$9.41

Bad debt expenses:

$3.74

$3.74

Costs of debt/equity capital:

$0.74

$0.74

Total costs:

$13.89

$13.89

Pretax profit:

$1.11

-$12.51

Source: Ernst & Young, “The Cost of Providing Payday Loans in a US Multiline Operator Environment,” 2009; recreated in Thomas W. Miller Jr., How Do Small-Dollar, NonBank Loans Work?, (Mercatus Center: 2019).

This chart also challenges the dubious argument that payday lenders make huge profits lending to the poor. One Federal Deposit Insurance Corporation paper of storefront payday loan profitability found no evidence of abnormally large profits, concluding:  “To a great extent, the high APRs implied by payday loan fees can be justified by the fixed costs of keeping stores open and the relatively high default losses suffered on these loans.”

Another study found that payday lenders actually fall far short in terms of profitability when compared to a mainstream commercial lender, with an average 3.6 percent profit margin for payday lenders and 13 percent profit margin for commercial lenders, respectively.

Further, for the abnormal profits theory to hold true, small dollar lenders must hold significant market power to be able to charge a rate of interest that is “artificially” higher than what would be charged in a competitive market. And yet the small dollar lending market is highly competitive, with more storefront payday locations than either McDonald’s or Starbucks, and numerous other substitute products, such as check cashing, pawnbroking, personal finance companies, banks, and more.

Further, credit is priced according to risk. If the risk of default is higher, that will be reflected in the price. A small-dollar loan is typically an unsecured loan to a borrower who has a poor credit history and is unable to access “traditional” forms of credit. Lending to higher risk individuals without collateral means that lenders have a lot to lose. In other words, the higher risk in large part accounts for the higher rate.

The market for credit is no different than any other market. The idea that lawmakers, rather than the laws of supply and demand, have the knowledge to set the appropriate price of credit is as absurd as it would be if we were talking about bananas or washing machines.

If an interest rate cap is set below the market rate, there will be a shortage of credit. If lenders are prohibited by law from pricing risk accurately, a lender will respond in a number of predictable ways: adjusting the contract terms and length, requiring higher collateral, or restricting access to credit altogether. Lenders will not magically make the same loans to the same consumers at a lower rate of return. Rather, the end result is that consumers will be left with less credit or credit on worse terms than before.

As Thomas Miller, a Professor of Finance at Mississippi State University, noted in his excellent new book, How Do Small-Dollar, NonBank Loans Work?: “Economic theory predicts that a 36 percent interest rate cap will result in zero supply of payday loans.” As Miller further details, even longer term installment lenders that offer loans of around $1,000 cannot cover their costs under a 36 percent rate cap. For example, one study that looked at the breakeven APRs of installment loans, in 2013 dollars, found that a $1,000 loan has a break-even APR of 77.86 percent, a $2,100 loan has a break-even APR of 42 percent, while only a $2,600 loan has a break-even APR of 36 percent. As Miller concludes, lenders “must increase the dollar size of the loans they make so that the increased revenue from the bigger loans exceeds the cost of making the loans. To make these larger loans, lenders engage in more rigorous underwriting, which means that fewer customers qualify as the loan size grows.”

Democrats often claim that they are the party that “believes science,” while the Republican Party, on the other hand, “denies science” (whatever that is supposed to mean). Yet, to believe that setting an interest rate cap so low that it is unprofitable to make a loan will somehow not reduce consumers’ access to credit is the economic equivalent of burying your head in the sand.

A responsible policy maker would at least attempt to reckon with the problem of what happens when you eliminate the choices of those who have little or no other options. Eradicating alternative financial products through a binding 36 percent interest rate cap will, at best, resort in people defaulting on other loans and obligations such as rent, working a second job to make ends meet, or going without essential goods and services. To be clear, these are options that people have always had but decided against, presumably because it is not in their best interest. At worst, they will be pushed into the hands of illegal, predatory lenders who charge even higher rates of interest and enforce them with violence—a practice sadly common throughout American history.

The economic literature on the impact of withdrawal of high-rate credit is clear. The authoritative consumer credit textbook, Consumer Credit and the American Economy, extensively summarizes the current literature regarding high-rate credit and finds no evidence of systemic problems with the use of current, legal, high-rate credit products. As the textbook concludes, the use of such products:

Indicate that high-rate credit users generally are those who economic theory predicts may benefit from such credit, and many of them are fully aware of what they are doing, even as critics see their choices as outrageously shortsighted.

Other examples abound. A recent natural experiment in New York, for instance, showed that withdrawing access to certain high-rate credit products led to an 8 percent rise in personal bankruptcies, particularly among households on low incomes. This result should not come as a surprise, as these products are commonly used to consolidate debts and provide household liquidity, which reduces the likelihood of bankruptcy.

Further, a New York Federal Reserve study examining two states that prohibit payday lending, Georgia and North Carolina, found that households in those states bounced more checks, filed more complaints about lenders and debt collectors, and filed for Chapter 7 bankruptcy protection at much higher rates than states that had not prohibited payday lending.

Another study, from Adair Morse at University of California, Berkeley, found that payday loans improved household financial well-being during natural disasters, concluding that small dollar loans are welfare-enhancing and that “a move to ban payday lending is ill advised.”

As Milton Friedman famously said: “Underlying most arguments against the free market is a lack of belief in freedom itself.” That is certainly true for high-cost credit. Those who would prohibit small-dollar credit disregard the ability of individuals to live their lives in the way that they see fit.

We should treat the less well-off with dignity and respect, not with paternalistic policies that substitute their preferences with those of lawmakers or bureaucrats in Washington.

You don’t eliminate hardship by taking away people’s choices. You eliminate hardship by offering people more and better choices. A 36 percent interest rate cap will do neither.