In addition to Google’s recently announced ban on payday loan ads, an update shared by David Graff, director of global product policy, says: “In the U.S., we are also banning ads for loans with an [Annual Percentage Rate] of 36 percent or higher.” It looks like Google is jumping onto the 36 Percent Rate-Cap Bandwagon.
Originally Published June 2016
This “36 percent and no more” mindset stems from a passing familiarity with large-dollar installment loans – particularly for automobiles and mortgages: With installment loans, the borrower knows in advance the size, number and frequency of the equal payments and the APR. Importantly, an installment loan “amortizes” – that is, part of each payment reduces the amount owed.
The competitive market for these large-dollar loans clears at a lower interest rate – meaning, these loans can be supplied to borrowers at a lower rate because the lenders make a risk-adjusted profit at these rates.
There is a basic economic difference, however, between large-dollar and small-dollar loan markets.
Consider a $30,000, 5-year automobile loan at 5 percent APR. Over its life, this loan generates $3,968 in interest income. A $300,000, 30-year mortgage at 3 percent APR generates $155,332 over its life. In these cases, low rates generate relatively high levels of interest income because the amounts borrowed are large and the length of the loan is long.
Now, let’s look at the details of a $1,000, 12-month traditional installment loan at 36 percent APR. The monthly payment is $100.46, and the total interest paid is $205.55 (that is, NOT $360). For a $500 loan with the same terms, the monthly payment is $50.23, and the total interest paid is $102.77.
If the rate is doubled to 72 percent, the monthly cost to the consumer increases only by $18.82 and $9.41, respectively. High rates generate relatively low levels of interest income because the amounts borrowed are small and the length of the loan is short.
If lenders, in any market, can supply loans and make a risk-adjusted profit, they will do so. More importantly, lenders will compete with one another to do so. Competition guarantees that the borrowers will receive loans at the lowest possible cost and highest possible customer service – in both large- and small-dollar loan markets. But governments sometimes do things that make competition dry up.
Today, more than 30 states have interest rate caps at or below 36 percent APR. These rate caps create a loan desert in the market for installment loans under $1,000. Why? Although there is demand for loans in this space, installment lenders cannot make a risk-adjusted profit with these APRs. Over time, interest income for a given loan amount does not change, but costs of doing business do. This leads lenders to migrate to larger loan amounts – leaving the unprofitable loan space – and a loan desert emerges.
In the early 1900s, a coalition formed between consumer advocates and capitalists to bring legitimate capital to the small-dollar loan market and wrest control of the market away from illegal loan sharks. At the time, state mandated usury caps were 6 percent. Their solution was bold and forward thinking – a rate of about 36 percent.
The cooperative efforts resulted in the Uniform Small Loan Law of 1916. Language in this model law for state legislatures said, “This rate should be reconsidered after a reasonable period of experience with it.” Certainly, 100 years exceeds a reasonable period of experience.
If the industry didn’t meet a need, it would have disappeared long ago. Because the cost of being in business has increased over time, however, a $300–$500 traditional installment loan is no longer profitable at a 36 percent interest rate.
The focus of policymakers – even Google’s advertisement policymakers – should not be on banning some loan products but on introducing more competition into the landscape. Reintroduce the $300-500 installment loans to borrowers. Let traditional installment lenders compete in this loan space against payday lenders.
State legislators, U.S. representatives and U.S. senators should fight for the freedom of their constituents to make their own choices from among nonbank supplied, small-dollar loan products.
How can policymakers reintroduce more competition along the small-dollar loan landscape? Take bold and forward thinking steps like those of the consumer advocates in the early 1900s – increase rate caps six-fold. Or be even bolder: Eliminate interest rate caps on traditional small-dollar installment loans. And Google can help, too, by making sure that consumers can research all the available options before taking out a loan.