Caps are great on heads, but no so great for cash advance lenders. Image from Wikimedia Commons.
One of the most common regulations on the cash advance industry is to cap interest rates. It may seem like it’s a good thing to do to protect consumers from unfair interest rates. In reality, interest rate caps are an unfair standard on cash advance loans. Furthermore, rate caps constrain businesses in an industry in which almost half of all loan lenders are small business owners.
The cash advance rate cap uses bad math
Many states have introduced initiatives that cap interest rates on loans, aimed at capping the rate of a cash advance, usually at 36 percent APR. It seems like an altruistic thing to do, but there are problems with a rate of 36 percent. First, one can hardly assess the fees on a cash advance or payday loan as APR. Annualized Percentage Rates should hardly apply to a loan that matures in two weeks or less. Assume a loan lender assesses a fee of $20 per $100 loaned. If that $20 fee were compounding once a month, the APR is 240 percent. If it is assumed to compound every two weeks, that $20 fee is 480 percent annual interest. However a fee of $20 per $100 assessed in simple interest, or a ratio of the total amount paid back to the amount borrowed, it is only 20 percent interest.
Cui Bono
The phrase “cui bono”, in Latin, basically means “Who Benefits?” In the case of a short term loan rate cap, the beneficiary is banks and credit unions. Credit cards look a lot more attractive than payday loans when APR is the standard. However, if the total a person pays back were divided by the total amount of credit used, as in simple interest, payday advance loans start to look a lot better.
Price ceilings are bad
Essentially rate caps function as price ceilings, where a business has to charge no more than a certain amount. This means that the margin for profit is drastically reduced, and the consumer cannot benefit from price competition. About 50 percent of all payday loan store owners are independent small business owners, not giant corporations. Is that who should be punished in this economy? You can read more in the Payday Loan Facts and Statistics Report on Personal Money Market.
