Just in time for Christmas, liberals in Congress have reintroduced lending restrictions on small-dollar, short-term loans (sometimes referred to pejoratively as “payday loans”). 

They suggest that this policy will help Americans save money, but instead, it will leave financially stressed individuals in a worse position.

What Happened

Recently, Senator Jack Reed (D-RI) and several other Senate Democrats introduced the Predatory Lending Elimination Act, a bill that would extend the Military Lending Act (MLA), which caps the effective interest rate on consumer loans (including fees) at 36%, to most consumer loans thereby making it applicable to all consumers. This is not the first time that a national rate cap has been introduced. It didn’t pass then and for good reasons.

In a statement Senator Reed unfairly blasted the small-dollar lending industry:

While servicemembers are protected by the MLA, predatory lenders, particularly payday lenders, continue to target vulnerable Americans with abusive loans that can reach APRs as high as 664%, trapping individuals in cycles of debt.” 

Sherrod Brown (D-OH) explained exactly which lenders they were targeting:

Payday, car title, and other shady loan practices target Ohio’s military families, veterans, and vulnerable consumers with high-interest, predatory loans that are designed to trap them in a cycle of debt.

So-called consumer advocacy groups were quick to pile on the praise, but will they take responsibility for the damage that this national policy would trigger for economically vulnerable Americans?

What This Means

My colleagues and I have written over and over about small-dollar lending. IWF dedicated a policy focus to explaining why about 7 million unbanked households Americans turn to non-bank lending services to help them when a financial need arises. Installment loans offer access to vital credit when other forms of cash or credit (such as credit cards, bank loans, and savings) are out of reach.

As Carrie Sheffield explained, “Non-Asian minorities, low-income households, less-educated households, young households, and households with disabled members are more likely to be unbanked than others…” The top two reasons households rely on alternative financial service providers instead of traditional financial institutions is that they don’t have enough money to meet minimum balance requirements and they don’t trust banks. The latter point is not surprising given the unsavory treatment blacks faced in the past or the experiences of immigrant populations in their home countries.

Small-dollar loans offer access to credit to high-risk individuals–those with low or no credit history–which explains the nominally high Annual Percentage Rate (APR) interest rates. These loans are not meant to be long-term solutions and they are often paid off quickly.

Leave it to Washington to break what works. The proposed national rate cap strikes at the heart of a system that is serving vulnerable individuals. As Carrie explained: 

However well-intentioned, policymakers’ plan to establish a national interest rate cap is counterproductive for people in need and could very well push them to underground financial products in an unregulated, shadow economy. The national interest rate cap plan would hurt the ability of low-income Americans—especially racial minorities, immigrants and young people—to tap loans that pay for bills like water and electricity.

Capping interest rates raises the cost of the installment loan and would drive lenders to end those products. Although the need for credit is still there, consumers will be left with no other lending options. History has shown us that consumers are forced to use even more pricey avenues such as higher-priced overdraft protection, bouncing personal checks or underground market alternatives.

When states instituted 36% rate caps, the outcomes were counterproductive. In Illinois, fewer people were able to take out much larger loans. Not the intended outcome.

Advocates for rate caps claim that in the absence of small-dollar loans, financial institutions will fill the gap with products that meet the needs of high-risk borrowers. When Southwest Public Policy Institute President Patrick Brennen put that argument to the test in New Mexico as a low-risk borrower (with great credit and income), he failed to secure any credit.

A national 36% rate cap will nationalize the hardship from state-level rate caps while failing to deliver the benefits.

Bottom Line

In this age of elevated inflation, American households need access to credit for bills and unexpected expenses. However, limiting interest rates on installment loans and other consumer loans will backfire, leaving them in hotter financial water. Expanding lending options, promoting financial literacy, and expanding income-earning opportunities are a better way forward.