Virginia lawmakers appear poised to “fix” an elusive “predatory loan problem”. They focus on the low dollar loan market which is allegedly teeming with “outrageous” interest rates. The bills before the assembly would impose an interest rate cap of 36% and change the market-determined nature of small loans.
Other state lawmakers across the country have passed similar restrictions. To improve consumer welfare, the goal should be to expand access to credit. Interest rate caps work against this, stifling the supply of small loans. These caps create shortages, limit trade gains and impose costs on consumers.
Many people resort to small loans because they do not have access to cheaper bank credit – they are “underbanked” in policy parlance. The FDIC survey classified 18.7% of all US households as underbanked in 2017. In Virginia, the rate was 20.6%.
So what will consumers do if lenders stop giving small loans? To my knowledge, there is no easy answer. I know that if consumers have a need for money, they will meet it one way or another. They: forgo paying bills; avoid necessary purchases; or turn to illegal lenders.
Advocates of interest rate caps claim that lenders, especially low dollar lenders, are making huge profits because desperate consumers will pay the interest rate lenders want to charge. This argument ignores the fact that competition from other lenders pushes prices to a level where lenders make a risk-adjusted profit, and no more.
Advocates of interest rate caps say the rate restrictions protect naïve borrowers from so-called “predatory” lenders. Academic research shows, however, that small borrowers are not naïve, and also shows that imposing interest rate caps harms the very people they are supposed to help. Some also claim that interest rate caps do not reduce the supply of credit. These claims are not supported by any predictions from economic theory or demonstrations of how loans made under an interest rate cap always pay off.
A commonly proposed interest rate cap is 36 Annual Percentage Rate (APR). Here is a simple example of how this makes some loans unprofitable.
In a payday loan, the amount of interest paid is equal to the amount loaned, multiplied by the annual interest rate, multiplied by the length of time the loan was held. If you borrow $ 100 for two weeks, the interest you pay is $ 1.38. So, under a 36% APR cap, the income from a $ 100 payday loan is $ 1.38. However, a 2009 study by Ernst & Young found that the cost of a $ 100 payday loan was $ 13.89. The cost of granting the loan exceeds loan income by $ 12.51 – probably more, since more than a decade has passed since the E&Y study. Logically, lenders will not make unprofitable loans. Below a 36% APR cap, consumer demand will continue to exist, but supply will dry up. Conclusion: The interest rate cap has reduced access to credit.
Currently, Virginia law allows an APR of 36% plus a verification fee of up to $ 5 and a fee of up to 20% of the loan. Thus, for a loan of $ 100 over two weeks, the total eligible amount is $ 26.38. Competition in the market likely means borrowers are paying less than the authorized amount.
Despite the predictable howls of contrary derision, a free market provides the best quality products at the lowest prices. Government interference in a market decreases quality or increases prices, or does both.
So, to the Virginia Assembly and other state legislatures that are considering similar measures, I say: be bold. Eliminate interest rate caps. Allow competitive markets to price small loans. This will expand access to credit for all consumers.
Tom Miller is Professor of Finance and Lee Chair at Mississippi State University and Adjunct Researcher at the Cato Institute.