Report: APR Calculation Misleading as Applied to Short-Term Loan Costs

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A new Competitive Enterprise Institute report criticizes efforts by lawmakers and activists to impose a cap on small-dollar, short-term loans based on a hypothetical annual percentage rate (APR) that is irrelevant to the product at hand.

“Using an annual percentage rate to calculate fees for short-term loans is misleading, because the loans are typically paid off in a matter of weeks, incurring a much smaller fee than a year-long calculation would imply,” said John Berlau, co-author of the CEI report.

“Worse, government-imposed fee caps on small dollar loans will discourage lenders from offering diverse, innovative loans to low- and middle-income consumers, the very people who may not have savings accounts or credit cards available to cover urgent, short-term expenses like car repair or a large, overdue utility bill,” said Berlau.

The report explains why fees – such as $15 per $100 borrowed over a two-week period, or $30 for a $200 loan – may seem high relative to the amount borrowed but are still preferable to many consumers to outcomes like defaulting on a debt, incurring bank overdraft fees, having a utility shut off, or being unable to pay for a car repair or rent.

Short-term loans and payroll advances, typically offered by “payday” lenders or, more recently, FinTech companies, are often not secured by collateral, such as an automobile, jewelry, or other valuable assets. So the relatively high fees reflect a risk of default that lenders take in offering unsecured loans, the report explains.

Small-dollar lenders, along with FinTech innovators like Earnin and Dave, provide a vital credit option to those who need it the most, the report explains. Lawmakers should police disclosure, but otherwise take a hands-off approach to encourage lenders to compete and innovate to offer consumers services that meet their needs and foster financial inclusion, regardless of wealth status.

The report also urges Congress to modernize the APR disclosure mandate from the 1968 federal Truth in Lending Act to account for the true cost of credit for short-term loans and advances.

View the report, The Annual Percentage Rate Is the Wrong Metric for Assessing the Cost of a Short-Term Loan; Use of Misleading Measure Can Justify Misguided Regulation by Matthew Adams and John Berlau