California passed new legislation to limit the amount of interest that can be charged on short-term, small loans. In effect, it will drive those lenders out of business and leave low-income Americans with less access to capital.
You might think that capping interest rates sounds reasonable. After all, no one wants poor people borrowing money at interest rates they can’t afford.
However, these small, high-interest loans are what many (poor) people rely on and prefer. While waiting for their next paycheck, they may not have emergency savings to cover a bill that’s due.
Short-term loans (also called payday loans) may be the best offer for those who don’t have good credit and can’t get the cash they need quickly. A high-interest rate is an incentive to repay the loan quickly and most people do.
When lawmakers limit interest rates on these loans, the lenders can’t afford the risk and costs and will stop offering these financing options. As a result, they shut down and Americans end up with fewer ways to access credit quickly when they need it.
As one California resident who testified against this bill explained:
“With this bill passing, we feel like you’re taking another option away from us and it’s very concerning. We need our options open.”
AB 539 is a bad idea. It’s paternalistic to tell people what to do with their own money — as though they haven’t already made the calculations for themselves. My colleague Charlotte Hayes made this point when the bill was introduced writing:
“…this is a decision that should be left to the borrower, not those, however well-intended, who are not familiar with the financial needs of those who, if careful, just might get out of a tight spot with a short-term loan.”
Democrats in the state also agree:
“Usually the ones who advocate for these programs are not the people who use these programs,”Sen. Ben Hueso (D-San Diego) said. “Telling people how to manage their finances, I don’t think it’s the government’s job to do that.”
We read that small-dollar or payday loans charge triple-digit interest rates. That’s certainly eye-opening considering that many of us shop around for the lowest interest rates on credit cards and loans — usually paying in the single to double digits.
California has made a sweeping policy based on the situations of a minority, not the majority of payday lenders. As the LA Times reports “more than one-third of California borrowers who take out loans with interest rates at 100 percent or more end up in default.” That means two-thirds borrow without defaulting. If lenders shut down, this bill will hurt all of these borrowers equally.
Let’s explain why interest rates on small, short-term loans are so high.
First, there’s a reason lenders charge high-interest rates. There are high fixed costs associated with running a business: rent, payroll, and capital. Lenders have to charge fees to turn a profit otherwise why get into the business?
If you think they are turning massive profits, think again. A report by the Federal Deposit Insurance Company (FDIC) finds that the high costs justify the high-interest rates.
Furthermore, the idea that profits are drawn from preying upon frequent borrowers or lots of poor people living in low-income neighborhoods is also not true or supported.
Second, lenders also have the cost of absorbing bad debts.
Americans with middle and upper incomes, savings, good credit, and assets can secure credit relatively easily and at low rates. That’s not true for the unbanked or underbanked. There are many low-income families who don’t have bank accounts but purchase everything with cash and debit or who can’t get access to money when they need it.
The risks of lending money to someone who doesn’t have assets, savings, or bank accounts is high because these asset sources raise the likelihood of him or her being able to repay the debt on time.
By capping the interest rates on small, short-term loans to 36 percent lawmakers may think they will help their constituents.
In fact, they will drive lenders out of business and reduce the access individuals have to credit.
The question that lawmakers have not answered is what happens when payday, car title loans, and other short-term loans are unavailable? The need for cash quickly doesn’t disappear even if the sources do. Unfortunately, we may see Californians turn to even less palatable options such as bouncing checks, pawn shops, and loan sharks.
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