South Carolina is debating implementing a 36 percent rate cap on short-term loans. If successful, it would be the 19th state to implement the 36 percent cap. Proponents of the legislation claim it will prevent predatory lending and protect consumers. Yet upon evaluating the effects of similar actions in other states, it becomes clear that the very people this measure aims to help will be harmed the most. The evidence demonstrates that a cap does not protect short-term borrowers but removes their access to legal loans entirely, forcing them to seek out credit through less desirable means.
Since the dawn of civilization, debates have arisen regarding the role and limitations of interest rates, with all Abrahamic religions addressing such practices as “usury.” In America, usury laws, which capped rates at around six percent in most states, hampered the development of a legal short-term loaning service. In its stead, low-income earners widely used illegal loan sharks, resulting in physical harm for failure to pay debts. The Uniform Small Loan Law of 1916 was established to give subprime borrowers a safe and legal credit alternative.
Since then, the debate has been reframed. Instead of short-term lending being an ethical alternative to loan sharks, it’s now deemed predatory. Forgetting why short-term lending exists, we are reverting to our previous system of usury laws, with the 36 percent rate cap being the most prominent example. Examining the results of these rate caps should remind legislators of why we first reformed lending in 1916.
Thomas Miller, Gregory Elliehausen and Brandon Bolen conducted a study on Illinois’s 36 percent rate cap, comparing it with its neighbor, Missouri, which had not implemented a cap. After enacting the rate cap, the number of loans to subprime borrowers decreased by 44 percent, while the average loan size increased by 40 percent. Lenders surmised that smaller short-term loans were simply not profitable under a rate cap of 36 percent. To cover overheads, lenders had to increase the minimum loan sizes.
Many policymakers overlook this point because they see rates of over 36 percent as being unreasonable when compared to long-term loans. What they don’t understand is that a 36 percent APR on a short-term, small-dollar loan is not high in practice. An example given by Steve Pociask in his paper “Recipe for Long-Term Disaster” demonstrates this point perfectly:
“Assume a consumer borrows $100 and agrees to eventually pay back $110 whenever they are able to do so. Under one scenario, if the consumer pays the loan back in one year, the effective APR is 10%. However, under another scenario, if the consumer pays back the loan in two weeks, the effective APR becomes 260%. Yet, the payback amount from the two loans is identical — $10. The only difference is the time frame.”
A higher minimum loan size priced out many subprime borrowers, forcing them to look elsewhere for credit. In the Miller study, borrowers were surveyed regarding their satisfaction with the results of the rate cap. Only 11 percent indicated that their financial well-being increased following enactment, and 79 percent wanted the option to return to their previous lender. Most weren’t able to borrow money when they needed it and indicated being unable to pay one or more bills.
If South Carolina passes its rate cap bill, the results are unlikely to be much different. The economics of supply and demand can help us to predict these results. As price controls are enacted on loans, a shortage ensues due to a restricted supply and steady demand. After studying the subject, this is exactly what researchers like Miller and others see occurring.
The worst policy can be made with the best intentions. Those who wish to cap rates see the plight of subprime borrowers and attribute their ills to the people loaning to them. In reality, these loans are subprime borrowers’ safest option when they need credit. If we truly wanted everyone to have access to credit, we’d allow the market to meet demand and not moralize over the rates necessary to supply it.
Isaac Schick is a policy analyst at the American Consumer Institute, a nonprofit education and research organization. For more information about the Institute, visit www.TheAmericanConsumer.Org or follow us on Twitter @ConsumerPal.