Limiting Interest Rates Without Limiting Access to Credit

Limiting Interest Rates Without Limiting Access to Credit

November 22, 2021 0 By administrator

Setting caps on interest rates can lead to unintended, negative consequences for borrowers.

Sir Isaac Newton famously postulated that for every action, there is an equal and opposite reaction. Although this principle is a cornerstone concept in physics, it is also quite applicable to the ongoing debate on Capitol Hill about federal interest rate caps on consumer loans.

Interest rate caps have received newfound attention from legislators seeking to moderate predatory lending practices within the small-dollar loan market. Proponents assert that these policies are necessary to protect vulnerable consumers from accepting usury loans—offered by payday lenders, pawnshop brokers, and other such outlets—that they cannot pay back, leading to “debt traps.”

Today, 18 states as well as Washington, D.C. have capped short-term loan rates to 36 percent or less, complementing federal interest rate limits that cover specific products and customers, such as the Military Lending Act (MLA), which applies to payday or installment loans to active-duty servicemembers. U.S. Senate Democrats introduced the Veterans and Consumers Fair Credit Act, which would build upon the MLA by setting a 36 percent federal interest rate cap applicable to all types of consumer loans.

Proponents of interest rate caps contend that such measures are vital for protecting consumer welfare, especially among low-income borrowers, but few acknowledge the significant, unintended consequences they engender for the very people they were meant to support.

The World Bank conducted a comprehensive review of six types of interest rate caps and that found these policies to have major adverse consequences for consumers, including increased non-interest fees or commissions, reduced price transparency, in addition to lower credit supply and loan approval rates primarily affecting small and risky borrowers.

The World Bank study also noted equally unfavorable effects for the financial ecosystem, including decreases in the number of institutions and reduced branch density stemming from lower profitability—effects which were particularly acute for small institutions focused on providing traditional depository or lending services, compared to large multinational conglomerates such as investment banks.

These findings have been echoed within similar analyses of small-dollar loan markets in the United States. A study by the Federal Reserve and George Washington University found that financial institutions within states with lower rate caps offered fewer small-dollar loans, most of which were completely inaccessible to low-income borrowers since their lending risk could not be accurately priced under the terms of state-mandated interest rate limits.

Another study conducted by the Consumer Financial Protection Bureau’s Taskforce on Federal Consumer Finance Law determined that arbitrary limits on interest rates would “undoubtedly” put lenders out of business and prevent middle-class and struggling…

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