If bills were judged only by their titles, it would be hard to find fault in Sen. Bernie Sanders and Rep. Alexandria Ocasio-Cortez’s latest proposal, the Loan Shark Prevention Act. But don’t be fooled. The crux of the bill is a 15 percent APR cap on all consumer loans, which would destroy the small-dollar lending industry and deny a vital source of credit to millions of American families.
For many types of loans, the Loan Shark Prevention Act would rarely be relevant. According to Credit Karma, “the average annual percentage rate on a two-year personal loan from a commercial bank was 10.22%, according to Federal Reserve data for the first quarter of 2018.” The average interest rate on a 60-month auto loan is just 4.21 percent.
However, credit card interest rates tend to be higher, averaging 15 to 21 percent, and most small-dollar credit (like a payday loan) carries higher rates.
Payday loans have high interest rates for a simple reason. Whether due to their own choices or circumstances outside their control, payday borrowers often aren’t very good credit risks. Because the risk of default is higher, lenders must charge higher interest rates on these loans in order to cover their losses and still turn a profit.
For these loans, arbitrarily capping annual interest rates at 15 percent would constitute a direct form of government price control — limiting the prices lenders can charge for their services. Throughout history, from the Babylonians and Egyptians to today’s policies of rent control, price controls have never worked, creating shortages that backfire on consumers.
But Sanders and Ocasio-Cortez don’t regard shortages in small-dollar lending as a drawback of their plan. Indeed, an explicit goal of their proposal is to destroy the payday loan industry, which they view as predatory and exploitative.
On the contrary, payday lending is a lifeline for millions of struggling households — those with the least amount of wealth and income — who’ve been shut out of the traditional banking system and need credit to cover unforeseen expenses or provide for basic necessities. With 4 in 10 Americans adults unable to cover an unexpected $400 expense, the government should not be taking steps to reduce access to credit for low-income households.
The consumer benefits of payday lending are clear. A 2016 survey revealed that 96 percent of payday borrowers say their loans have been useful to them personally, with 66 percent saying they have been very useful. Research has found that access to payday loans is correlated with fewer foreclosures after natural disasters, fewer bank overdrafts, and better household financial health. In addition, the vast majority of payday borrowers “accurately predict how long it will take them finally to repay their payday loans.”
It’s also important to consider that the short-term alternatives to payday loans — such as bouncing a check, incurring a late fee on a credit card bill, paying late/reconnect charges on a utility bill, or relying on the criminal underground for funds — are often even more costly.
Some critics complain that payday loans offices are cropping up everywhere, with more than 20,000 locations around the country. President Obama famously observed that Alabama has four times as many payday lenders as McDonald’s restaurants. But why is that a bad thing? Intense competition drives down prices and gives consumers more choices. Indeed, despite popular claims to the contrary, payday lenders are not making outsized profits. A 2007 study found that payday lenders earned an average profit of 7.63 percent, compared to 7.9 percent among all firms.
We’ve been down this road before. Well-intentioned anti-usury laws, which were meant to protect the poor from exploitation by greedy bankers, have a long history of achieving precisely the opposite of their intent. By forcing legitimate enterprises out of business, these laws drove the small-dollar lending industry underground, empowering the very loan sharks they had sought to combat. In New York during the 1930s, for example, anti-usury caps spawned a vast criminal loan racket with 1,040% interest rates and brutal collection methods.
The lesson should still resonate today: When legitimate sources of credit dry up, the poor will seek it out in the world of loan sharks, pawn shops, or illegal lending — where no legal protections exist.