Freedom to Borrow

Imposing interest rate caps on loans and restricting the credit options available to consumers are ill-conceived policies that do not achieve their desired outcome. Such policies unfairly target short-term, small-dollar loans that many disenfranchised and disadvantaged people use. People with subprime credit scores or “underbanked” or “unbanked” people often rely on these types of loans and other creative financing solutions to access credit for car repairs, to pay rent, or in a medical emergency.

What Are Short-Term, Small-Dollar Loans?

A short-term, small-dollar loan is a loan ranging from $50 to $1,000 with the average being $375. Borrowers pay back the loan in full, plus the interest rate, usually within 14 days.

These types of loans are usually taken out by individuals who are short on cash and need money for an expense before their next paycheck—individuals who, without this credit, would otherwise be unable to afford an unexpected expense. Three in ten Americans lack the savings to cover an emergency expense of $400. Some examples: a necessary car repair, a medical emergency, or a security deposit on a new apartment.

Click HERE to learn about some examples of short-term, small-dollar loans.

Who Uses Short-Term, Small-Dollar Loans?

• A young person with insufficient credit history to qualify for a traditional credit product.

• An otherwise creditworthy consumer with a sudden destabilizing financial experience.

• A recent immigrant who lacks a credit history.

• A person who has a history of being irresponsible with credit and who is thus unlikely to be approved for traditional  credit products.

It’s important to understand:

• 47% of U.S. consumers are non-prime or credit invisible (often recent college graduates and immigrants), which means they have credit scores below 660, unscoreable credit, or no credit score at all.

• 36% of American households are financially insecure in 2024.

• 57% of people surveyed by LendingTree say they experienced some level of difficulty in paying their usual household expenses over the past seven days.

• Americans’ total credit card balance is $1.233 trillion—the highest balance since the New York Fed began tracking in 1999.

What Are Rate Caps and Why Are They Bad for Consumers?

An interest rate cap is a limit on how high an interest rate can rise, and thus how much a financial institution can charge a borrower for borrowing the money. At first glance, this seems like a consumer-friendly policy. However, a rate cap restricts access to credit for those who lack access to traditional financial institutions. Interest rate caps also limits the amount of options a consumer has at their disposal.

A rate cap at any level would result in the erosion of the freedom to borrow.

Many disadvantaged people have no bank account or face tenuous financial circumstances. They often rely on a safety net of innovative alternative, short-term forms of credit, which sometimes carry higher interest rates. Instituting a rate cap could run the risk of excluding many individuals from the credit community and completely “unbanking” them.

Short-term, higher-cost, and single-payment loans can be an affordable and attractive form of credit for many Americans whose credit scores are sub-prime. Such loans are also superior to desperate alternatives like bouncing a check, bankruptcy, or piling up debt on a credit card and paying only the monthly minimum, or worse.  

Click HERE to Learn Why 36% Is So Often Proposed as an Interest Rate Cap

Click HERE to Learn the Lesson from Illinois

DIDMCA Gives Credit Consumer Options

Thanks to a unanimous 1978 decision by the U.S. Supreme Court, banks holding a “national charter” were to be governed by the interest rate caps of the states in which they were based instead of the state in which the consumers lived. The nationally chartered banks started offering very attractive terms across state lines.

In response to the Supreme Court’s decision, Congress passed a bill called the Depository Institutions and Monetary Control Act of 1980 (DIDMCA), which allowed banks chartered under state law to have the same right to “export” their home-state interest rates as the national banks did.

The result of DIDMCA’s passage was vibrant competition among all banks—nationally and state-chartered—to provide more and more attractive terms on credit and to provide more credit options as well as to provide credit to more and more people. This especially benefited millions of previously credit-deprived and underbanked customers who were brought out of the margins and into the mainstream credit community. This helped fuel the economic expansion of the 1980s and beyond.

Unfortunately, in passing DIDMCA, Congress included a provision that would allow state legislatures to opt out of the law. At first, several states opted out. Over time, all but Iowa rescinded their opt-out laws after seeing the benefits to consumers in the other states.

It sounds absurd, but lawmakers in various states are now thinking about opting out of DIDMCA and setting back the most economically vulnerable families 50 years. They often couch their opt-out schemes in terms of fairness and consumer protection (an attempt to keep higher-interest rate consumer loan products from being offered in their states). In reality, their bills implode credit access for consumers and small businesses. They also place their state banks at a disadvantage compared to the massive, impersonal, nationally chartered banks, which are charging the highest fees and are exempt from state DIDMCA opt-outs.

Resources

Credit for Me but Not for Thee: The Effects of the Illinois Rate Cap

This study uses a consumer survey and finds that a 36% interest rate cap imposed in Illinois in 2021 significantly decreased the availability of small-dollar credit, particularly to subprime borrowers, and worsened the financial well-being of many consumers.

Price Regulation in Credit Markets: A Trade-off between Consumer Protection and Credit Access

This study shows that when interest rates were forced lower, the number of loans also decreased.

Interest Rate Caps: The Theory and the Practice

This study shows that the unintended side-effects of interest rate caps can include increases in non-interest fees and commissions, reduced price transparency, lower credit supply and loan approval rates for small and risky borrowers, and a lower number of institutions and reduced branch density.

No Loan For You, Too!: The Unintended Consequences of Price Controls on Consumer Access to Credit

This study shows that while some of the largest nationally chartered banks advertise the availability of low-interest, small-dollar loans, consumers in need find them virtually unattainable.