The Obama administration recently announcement new regulations that extend the Military Loans Act of 2006. The MLA caps payday loans to military personnel at an annual percentage rate of 36%. Why do we trust our volunteers in the military to make life and death decisions, but forbid them from making a financial decision to pay the typical $ 60 cost of a $ 300 payday loan on two weeks ?
With or without payday lenders, the demand for short-term credit will always exist. Moreover, illegal lenders will happily provide $ 300 short term loans. They typically charge $ 60 in interest for one week, not two weeks.
The MLA effectively prohibits payday loans to military personnel. A two-week $ 300 payday loan with a 36% APR would generate $ 4.15 in interest income. This cost to the consumer is roughly equal to the average cost of an off-grid ATM. load. An ATM withdrawal is risk-free, but a payday lender faces production costs, including the risk of default, that are well over $ 4.15. Therefore, payday lenders will not provide loans capped at 36% APR.
The new regulations will extend the 36% cap rate to other types of small loans to military personnel, including installment loans. Unlike payday loans, installment loans are repaid in equal installments and the amount owed decreases over time. These new regulations limiting interest rates are the latest in a long line of flawed laws and regulations that restrict or deny access to important consumer credit products. Interest rate caps, like other price controls, have serious unintended consequences.
Is a 36% annual interest rate for a small loan too high? Those who say “yes” probably have a view of the world shaped by high-value mortgages or auto loans. But there are many reasons people need to borrow money. Millions of Americans rely on small loans not provided by banks to meet large credit demands, such as the purchase of durable goods or unexpected auto repairs.
The National Center for Consumer Law says that an annual interest rate cap of 36% is validated by a “long and well-known history in America dating back 100 years. “As Lone Ranger fans have often heard, please” come back with us now to those exciting days of yore. “
In the progressive era of the early 20th century, credit reformers understood that the needs of borrowers and lenders had to be met to create a sustainable market-based alternative to illegal “loan sharks”. These reformers sought to pass state laws allowing approved lenders to provide small loans at rates above state-imposed interest rate caps, then typically 6%.
Partnering with lenders willing to risk capital by making loans repaid in equal installments, reformers developed the Model Uniform Small Loans Act of 1916. Through rigorous studies, reformers determined that costs and small loan risks deserved an annual interest rate. about 36%. In 1916, $ 300 or less was considered a small loan ($ 6,900 in 2015 dollars).
Small installment loans remain an important non-bank consumer credit product. Installment lenders carefully identify potential borrowers who will be able to repay the loan. Only about half of people looking for an installment loan get one. Those refused must find another source of credit.
During a recent conference of state legislators, this question arose, “Why can’t installment lenders make money at 36% APR?” They can if the amount borrowed is large enough to generate enough interest income to cover the costs and risks of granting the loan. A $ 300 12-month, 36% APR installment loan generates $ 61.66 in interest income. Why were $ 300 installment loans profitable in 1916, but not in 2015? Although the interest income is the same, the costs of producing loans, including salaries, benefits, rent, and utilities, have increased significantly over time. The consumer price index is about 20 times higher in 2015 than in 1916.
The Uniform Small Loans Act 1916 states that a rate established by lawmakers “should be reviewed after a reasonable period of experience with it”. Obviously, the next 100 years is “a reasonable period”. Today, a $ 300 installment loan is simply not profitable at an interest rate of 36%. Neither do payday loans. The result is that a legal lending desert exists in the low dollar lending landscape. There is demand, but no supply.
Consumer advocates, regulators, and lawmakers need to be courageous and do what far-sighted reformers did 100 years ago: allow much higher interest rates on small loans. The cost to consumers is low. An APR of 108% on a $ 300 12-month installment loan costs only $ 2.94 per week more than a similar loan at an APR of 36%. Consumers should have the choice of paying this paltry sum. The insignificant amount can help eliminate the loan desert.
Thomas W. Miller Jr. is Professor of Finance, Jack R. Lee Chair in Financial Institutions and Consumer Finance at Mississippi State University, and Visiting Fellow at the Mercatus Center at George Mason University. Chad Reese is the Deputy Director of Outreach for Financial Policy at the Mercatus Center. Research Assistant Mercatus Center Vera Soliman and Carolyn Moore Miller contributed to this piece. The views and opinions expressed here do not necessarily reflect those of Mississippi State University.