A Single Federal Usury Cap is Too Blunt an Instrument

NB: This post is part of a debate on the Loan Shark Prevention Act, a bill that would introduce a federal usury cap. Emma Caterine’s response is here.

Anne Fleming–

In May 2019, Senator Bernie Sanders and Representative Alexandria Ocasio-Cortez unveiled the Loan Shark Prevention Act, a bill that would cap the cost of consumer credit nationwide. Under the bill, the total cost of a loan, calculated as an annualized percentage rate (APR), could not exceed 15%.

Although high credit card charges are the bill’s main target, payday loans rank among the most expensive forms of consumer credit in the United States. A typical payday loan from a storefront lender costs $15 per $100 borrowed. For a $350 loan that must be repaid in one lump sum in two weeks, the borrower would pay $52.50 in fees. This equates to a 391% APR.

Payday lenders argue that it is misleading to calculate the cost of their products in terms of an APR because payday loans are not marketed for long-term use. But most borrowers cannot repay their loans in full in two weeks. Instead, they pay only the fee and rollover the balance into a new two-week loan. In this way, consumers can end up in a months-long cycle of borrowing, paying hundreds of dollars in fees. This vicious cycle is especially concerning because most borrowers are low-income, just making ends meet. Furthermore, Hispanic and African-American households account for a disproportionate share of payday loan users.

In other words, high-cost credit is a real concern that policymakers must address. But a one-size-fits-all 15% APR cap is a blunt instrument for tackling this problem.

A cap that makes sense for a large, long-term loan, like a home mortgage, will not work for a small-dollar, short-term one. For example, a 15 percent annual rate of charge on a year-long loan of $10,000 would equate to a fee of $1,500 – likely more than enough for the lender to cover its costs. But a 15 percent annual charge on a one-month loan of $100, equivalent to a monthly rate of 1.25%, yields a fee of just $1.25.

If fees and interest are capped at 15% APR, lenders cannot recoup the costs of making and servicing small-dollar, short-term loans. Only charitable or government-subsidized institutions could lend at that low rate.

 

All states cap small-dollar loan rates above 15% APR

Most states already experimented with one-size-fits-all interest rate caps a century ago, and rejected them in favor of more tailored approaches. In the early twentieth century, most states had usury laws that applied to nearly every type of loan, regardless of loan size or length. Most allowed lenders to charge no more than 6 or 7 percent per year. Commercial banks could lend large sums at these rates, but small-dollar lenders could not cover the costs of doing business.

Low rate caps did not extinguish the demand for small loans, however. They just discouraged legitimate enterprises from entering the market and left borrowers to the mercy of those willing to violate the law.

So, over the course of the twentieth century, states adopted higher rate caps for small-dollar loans. Many enacted some version of the Uniform Small Loan Law, a model lending law which allowed licensed lenders to charge up to 3% per month on the declining loan balance, with lower rates on larger loans. (My book, City of Debtors: A Century of Fringe Finance (2018), explores this history in more detail.)   Today, all fifty states allow licensed lenders to charge above 15% APR on short-term, small-dollar loans. As of 2017, the maximum APR allowed in states with rate caps ranged from a low of 16% (North Carolina) to 305% (Mississippi) for a $500, six-month installment loan.

 

Banks and credit unions

Even credit unions cannot make small-dollar, short-term loans at 15% APR. That is why the National Credit Union Administration (NCUA) currently allows federal credit unions to charge up to 28% APR for loans made under its payday alternative loans (PALs) program. And even this rate cap seems to be too low. As of 2018, only 9% of federal credit unions offered PALs. Accordingly, NCUA is considering raising the maximum charge allowed for PALs to afford credit unions the revenue necessary for them to invest in automating the loan origination process and scaling up the program.

In addition to the NCUA, other banking regulators have likewise sought to encourage depository institutions, such as banks and credit unions, to make small-dollar, short-term loans. In May 2018, the Office of the Comptroller of the Currency (OCC), which supervises national banks, announced that it would encourage banks to offer short-term, small-dollar loans.  And in November 2018, another banking regulator, the Federal Deposit Insurance Corporation (FDIC), requested public comments on how it could encourage FDIC-supervised institutions to make small-dollar loans.

Encouraging banks and credit unions to offer small-dollar loans could reduce the cost of borrowing for consumers nationwide. As researchers at Pew Charitable Trusts have observed, banks and credit unions have a lower cost of capital than non-bank lenders, and can spread their overhead costs among the multiple product lines. Furthermore, they also have lower underwriting expenses, thanks to automation, and can acquire customers at lower cost because of existing relationships with potential borrowers. Three-quarters of households that use any form alternative financial services already have an account with a bank or credit union, and all payday loan borrowers do as well.

Thus, banks and credit unions enjoy some key advantages that allow them to offer small-dollar loans at lower rates than payday lenders. But they still cannot lend at 15% APR. By imposing that cap, the Loan Shark Prevention Act would halt the development of payday loan alternatives by private banks. Only credit unions, which are exempted from the bill, could continue to offer small-dollar credit.

 

A public option

Near the end of their proposal, the sponsors of Loan Shark Prevention Act acknowledge that capping credit charges will not curtail the demand for small-dollar loans. Accordingly, they propose offering loans through a postal bank to meet this need.

Work by law professor Mehrsa Baradaran, has helped to garner political support for postal banking and generate public interest in the idea. But postal lending still merits more careful discussion than it has received to date.

Creating a postal lender, or another public option for small-dollar loans, would open a new chapter in the history of small-sum lending in the United States. The United States once had a postal bank, but it did not offer loans – only savings accounts. Thus, there is no direct American precedent on which to draw.

So far, Senator Kristen Gillibrand (D-NY) is the only politician to introduce legislation outlining how a postal lender would operate in concrete terms. In addition, the Inspector General of the United States Postal Service (USPS) also authored a paper on postal banking in 2014. These proposals offer two different models for postal loans. Gillibrand’s 2018 bill would cap annual rates on postal loans at “101 percent of the Treasury 1 month constant maturity rate,” which is currently less than 3%. In contrast, the USPS paper estimates that it would need to charge much more: $48 in interest and fees on a $375 loan repaid over 5.5 months.

As the differences between Gillibrand’s bill and the USPS proposal suggest, key questions about the design of a public option for small loans remain, and these deserve more attention and debate. They include: what role should the public option play in relation to private industry? Should the public option price loans below cost and, if so, would public resources be better spent on grants of money rather than subsidized loans for some households? And who will be eligible to borrow, how much can they borrow and on what terms, and how will payments be collected?

My own view is that creating a public option for small-dollar loans does not necessitate regulating the private industry out of existence through a 15% APR cap. Indeed, the “public option” label is no longer appropriate if the public option is the only option.

 

A path forward

Rather than sideline private industry with a low annual rate cap, Congress and federal regulators could employ other means to address the legitimate concerns that underlie Sanders and Ocasio-Cortez’s bill. They could adopt policies to encourage banks and credit unions to enter the small loan market, while debating the design of a public option for small-dollar loans. To address affordability, Congress could also require payday lenders to assess a borrower’s ability to repay the loan, as proposed by the Consumer Financial Protection Bureau in 2017. (The agency has since delayed the effective date of this rule and will likely rescind it.)

The Loan Shark Prevention Act is a welcome sign that some members of Congress are ready to lead the charge to create a minimum floor of regulatory protections for small-dollar borrowers. Adopting a one-size-fits-all rate cap is a flawed strategy. But the federal government can and should take other steps to prevent low-income Americans from being trapped.

Anne Fleming (@AFlemingEsq) is Professor of Law at Georgetown University Law Center.