Should Installment Loans Be Subjected to Interest Rate Caps?

Although many payday lenders offer installment loans as well as payday loans, the two products are quite different. Payday loans require repayment in full within a very short time, which can be as little as 14 days. Installment loans, however, are repaid through multiple monthly payments. Many different lenders, including credit unions and banks, offer personal installment loans.

When the Consumer Financial Protection Bureau, also known as the CFPB, released proposed guidelines for regulating payday loans, the agency also included regulations for installment loans. The new guidelines, which are scheduled to become effective in September 2016, include interest caps on installment loans.

In addition to the CFPB, many state legislatures are considering or have already enacted laws that limit the maximum annual percentage rate on installment loans to 36 percent. Many people are wondering whether installment loans should be capped at 36 percent as well as why so many lawmakers believe that this is a fair rate.

Should Interest Rates be Capped at 36 Percent for Installment Loans?

Installment loans are available in two types. Secured installment loans require the borrower to pledge collateral. If you finance a car, for example, the lender can repossess it if you fail to make your payments. A mortgage is another type of secured installment loan; if you fail to make your payments, the lender can foreclose. Because the lender has greater confidence that the loan will be repaid or that he will receive a tangible asset if it is not, interest rates on secured installment loans are typically much lower than the rates on unsecured loans.

With an unsecured loan, however, you do not pledge collateral. Lenders have little more than your word that you will repay the loan. Should you default on the loan, lenders will typically need to pursue collections through a third-party agency or a lawsuit. Because of the additional risk involved, lenders tend to charge higher interest rates on unsecured loans than they do on secured loans.

Lawmakers have typically allowed lenders to assess interest rates that recognize the level of risk involved. Many high-risk credit products are exempt from state usury laws as long as lenders make borrowers aware of the interest rates and other fees. For example, back in 2010, Premier Bankcard offered credit cards to borrowers with poor credit scores that carried annual percentage rates of up to 79.9 percent. Because the borrower was advised of the interest rate and other terms, the offerings did not violate any laws, according to Even today, the interest rates on credit cards offered by banks to subprime borrowers can exceed 36 percent.

Given the risks that lenders accept when making unsecured installment loans, it seems unreasonable to cap the interest rate at 36 percent. Payday lenders are objecting to the rate cap, but so are the Credit Union National Association, or CUNA, and the Independent Community Bankers of America. According to the Credit Union Journal, these two organizations recently sent a joint letter to the CFPB protesting the proposed rate cap. The letter warned that community banks and credit unions may be unable to make small-dollar loans if the proposed regulations are enacted. Under the new regulations, lenders cannot charge more than 28 percent interest and a fee of no more than $20. To charge 36 percent, the lender must have a default rate of 5 percent or less. CUNA advised the CFPB that its members’ actual default rate is almost 10 percent, eliminating this option.

Why Is 36 Percent Such a Popular Rate?

Many states have set 36 percent as the maximum interest rate that lenders can charge under the state’s usury laws. The history of the 36-percent cap dates to the early 20th century. At the time, illegal lenders were charging interest rates of more than 999 percent, but state usury laws typically allowed legal lenders to charge no more than 6 percent. Therefore, legitimate lenders were much more inclined to offer high-dollar loans to businesses than they were to offer small-dollar loans to consumers.

Reformers sought to combat illegal lenders by making it possible for legitimate lenders to charge an interest rate that allowed them to accept the risks and absorb the costs associated with these types of loans while remaining profitable. At the time, proposing an interest cap of six times the standard limit was considered somewhat radical. However, between 1914 and 1943, most states adopted a rate of 36 percent to 42 percent for small-dollar consumer loans. Today, 70 percent of the states cap small-dollar consumer installment loans made by lenders other than banks at 36 percent. However, most states allow lenders to add origination fees, application fees or other charges that can increase the annual percentage rate to more than 36 percent. The pending CFPB regulations would all but eliminate these extra fees, making it unprofitable for many lenders to continue offering these loans.

It is important to remember that the forward-thinking reformers recommending a 600-percent increase in prevailing interest caps never intended for the 36-percent rate to be the permanent cap. As the author notes in a recent article appearing in U.S. News, the reformers recommended that the rate be evaluated for revision following a “reasonable period of experience.” Surely, more than a century of experience qualifies as a reasonable period for lawmakers to realize that the 36-percent cap is unrealistic.

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