A national interest rate cap would harm consumers in the name of consumers

The California legislature just passed a financial policy that would have dreadful consequences for the consumers it seeks to protect. Congress is considering a similar measure as Senator Richard Durbin (D-Ill.) reintroduced a bill and the House Financial Services Committee held a hearing on the issue and could mark-up legislation.

The proposed bill would impose a nationwide interest rate limit of 36 percent. The implicit targets of this bill are payday and other lenders who charge high interest rates for small loans. Far from protecting lower-income consumers from “predatory lending practices,” however, a national rate cap of 36 percent would effectively cut credit lines to roughly 12 million payday consumers, many of whom have few other legal options for borrowing.

Also troubling, the proposed rate cap would likely eliminate the installment lending market, as well. Installment loans, which have average annual interest rates of 40 to 90 percent, represent the closest alternative to payday loans. They are used by an estimated 10 million consumers each year.

That the 36 percent rate cap would be so harmful for consumers might not be obvious. But the reasoning is straightforward. Interest rates are simply the price we pay for credit. Factors such as the lender’s costs and risks, the bank’s desire for profit, and consumer demand for credit all affect how expensive or inexpensive credit will be.

At bottom, interest rates are not so different than the cost of a cup of coffee or a gallon of gas. Far from arbitrary, these prices are contingent on a variety of factors, just like interest rates.

A national rate cap is essentially a price control. According to basic economic theory, applying an artificially low price will likely result in an artificially low supply.

Thankfully, we don’t need to rely on analogy or theory to consider the merits of an interest rate cap. It’s not exactly a new idea, after all.

One example: Between 1979 and 1986, 34 states removed or relaxed their rate caps for various reasons. Credit card issuers in the 16 states with restrictive caps rejected more applicants, charged higher fees and offered lower credit limits over the next few years.

Summarizing the historical evidence on the effects of rate caps, the authors of Consumer Credit and the American Economy concluded, “state interest rate ceilings restricted credit availability…for higher-risk borrowers.”

Rate caps, according to proponents, are supposed to protect financially vulnerable Americans, not cut their access to loans. So, why would they have this effect? To answer this question, we have to dig a little deeper into how credit is priced.

Fixed costs, including things like employee salaries and building rent, are especially important in the pricing of credit. These costs apply to all loans a lender makes, whether they be for $100 or $100,000, and interest rates help lenders recoup them. As a general rule, the smaller the loan, the higher the necessary interest rate. Conversely, banks can usually afford to attach smaller rates to larger loans.

Tom Miller, professor of finance at Mississippi State University, sheds light on this dynamic in his book How Do Small-Dollar, Nonbank Loans Work? “Although a 36 percent interest rate might sound ‘high’ and ‘profitable,’” Miller writes, “personal installment loans are profitable at that rate only if the loan exceeds a certain size threshold.” 

He then demonstrates that, under a 36 percent interest rate cap, loans with principal less than $2,600 fail to turn a profit.

By restricting lenders’ use of interest rates to drive revenue, the 36 percent national rate cap would incentivize lenders to make more large, long-term loans to recoup their fixed costs. An unfortunate side effect of this incentive structure would likely be the shutting out of riskier borrowers or borrowers seeking smaller lines of credit.

“To make these larger loans,” Miller writes, “lenders engage in more rigorous underwriting, which means that fewer customers qualify as the loan size grows.”

Mandating an annualized rate of 36 percent would effectively eliminate small-dollar loans as a credit option for millions of financially vulnerable Americans. To where will these consumers turn should the proposed bill pass?

Interest rates are objective tools used to ensure Americans retain access to demanded credit. Congress might be able to legislate small-dollar lenders out of business, but it can’t legislate away the consumer need for small dollar loans. The proposed national interest rate cap ignores how interest rates work in service of an “us vs. them” political story.

Considering how a national rate cap would harm vulnerable consumers, the policy could be characterized more accurately as “us vs. us.”

Beau Brunson is director of policy and regulatory affairs at Consumers’ Research. Joe Conway is a research fellow at Consumers’ Research.