South Dakota Votes to Restrict Interest Rates on Installment Loans at 36 percent
According to The Herald, when South Dakota residents went to the polls this year, many of them did so to shake up the government. They also voted to limit interest rates for online installment loans, auto title loans and payday loans. They even blocked legislation put forward by a Georgia-based lender that would have permitted a change in the state’s constitution. If voters had accepted this change, it would have allowed lenders to charge any interest rate that they wanted to charge as long as a borrower agreed to the terms in writing.
When did 36 Percent Become the Accepted Interest Rate?
The 36 percent interest rate has a long history, one that goes back about 100 years. Historians have traced it to the early 20th century. At the time, legal usury rates were around 6 percent. This rate was too low to support issuing small loans to consumers. Because of this, a small-dollar loan black market formed. When early borrowers took out a black market loan, the money had to be repaid by the person’s next payday. The annual rates for these loans were more than 1,000 percent.
When word of these excessive interest rate loans came out, reformers jumped into action by lobbying for the Uniform Small Loan Law. This law featured incentives designed to inspire legitimate lenders to dip their toe into the small loan market.
Thirty-four states embraced some version of the law, which came with rates that ranged from 3 percent to 3.5 percent a month and totaled 36 percent to 42 percent annually. Research, practical experience and political compromise resulted in the rate caps.
The 36 Percent Rate Cap Continues to Captivate States
The National Consumer Law Center reports that more than 35 jurisdictions have rate caps of 36 percent or less in place for installment loans. Lobbying efforts by the lending industry has brought about interest rate deregulation in a number of states, but when voters have a choice, most support rate caps. In 2010, 72 percent of Montana voters approved limiting interest rates to 36 percent. Ohio and Arizona voters did the same in their state.
As of 2013, 16 jurisdictions took action against high cost lending either by banning payday loans altogether or by limiting them to the 36 percent interest rate or less. But, is this the right approach? It may be time to put a moratorium on interest rate regulations.
An Economic Difference Between Large-Dollar Loans and Small-Dollar Installment Loans
When large-dollar loans are compared to small-dollar installment loans, there is a basic economic difference. For instance, if a borrower takes out a $30,000 automobile loan for five years at a rate of 5 percent, the loan will produce $3,968 in interest income. Mortgages also generate sizable interest totals due to the large amount of the loan’s principal balance. With these loans, low interest rates produce relatively high amounts of interest income since the principal loan balances are high and the loan lengths are long-term.
When considering a small-dollar loan with a shorter payoff time, the total amount generated is much less. For instance, with installment loans online, if a borrower takes out $1,000 with a 12-month payoff term at 36 percent, then the total interest generated is $205.55. Installment loans for $500 under the same terms would produce $102.77 in total interest.
If lenders double the rates to 72 percent annually, then the monthly cost to the borrower rises by $18.82 and $9.41 respectively. Even when rates are high on low dollar loans, they produce limited amounts of interest income.
Allowing the Market to Self-Correct
According to U.S. News, competition guarantees that consumers will consistently receive loans at the lowest possible cost while enjoying the best customer service. Competition causes this to happen because companies make risk adjustments on their own to stay viable. However, government interference can cause competition to diminish.
Today, more than 30 states have enacted regulations that cap interest rates for online installment loans at 36 percent or less. Connecticut is one state that has it capped at less. There, interest rates are limited to 12 percent. When limits like this are in place, it decreases the availability of installment loans for amounts that are $1,000 or less. Why does this happen? It happens because while there is a demand for small-dollar loans, installment lenders are unable to earn a profit when the annual percentage rate is capped at 36 percent or lower.
With loan caps, the amount of interest that a lender can earn remains unchanged over time. However, business costs tend to shift, and in most cases, they increase. This situation causes lenders to transition into offering large-dollar loans, decreasing the availability of installment loans for bad credit.
The Installment Loan Industry Clearly Meets a Need
If small-dollar loans didn’t fulfill a need, then this area of the industry would have disappeared by now. Because of this, lawmakers should be researching ways to bring more competition to the installment loans online arena. It’s time to bring back installment loans that fall into the $300 to $500 borrowing range.
Senators, U.S. representatives and state legislators need to work together to give their constituents the freedom to make their own borrowing choices from among the nonbank backed, small-dollar installment loans that are available.
How Can Lawmakers Bring Competition Back to the Installment Loan Industry?
To bring competition back to the installment loan industry, lawmakers could increase rate caps. They could also take the unlikely step of eliminating rate caps entirely on traditional small-dollar loans. Lawmakers could even learn from history and pass regulations that would tempt traditional lenders back into the mix.
While Google recently blocked the ads for payday and title loan lenders, the search engine can help legislators by making sure that borrowers have access to the loans that are available. This will allow borrowers to complete their own personal research before selecting a loan.
Voters in South Dakota Usher in Tighter Restrictions
With voters in South Dakota capping interest rates on installment loans at 36 percent in their state, it’s clear that everyday citizens have trust issues with the lending industry. What’s unclear is whether lenders can stay in business with restricted rates. If they can’t, then borrowers may have trouble gaining access to installment loans for bad credit. To learn more about the interest rate restrictions that are sweeping the country, visit the Personal Money Store.