Why is 36% used in Interest Rate Caps so often?

Where did the 36 percent number come from? Consumer advocate Arthur Ham wrote The Chattel Loan Business over a century ago, in 1909, and found by trial and error that he could attract investors to make loans at 3.5 percent per month for loans up to $100 and at 2.5 percent per month for loans above $100. The average of 2.5 and 3.5 is 3.0, and the 36 percent annual interest rate was born. An important fact to note: Unlike current proposals to impose a 36 percent rate cap, Ham’s 36 percent annual interest rate was not an APR as people know them today; with his rate, he allowed for the addition of fees and ancillary product charges.

Also, it is important to note: The 36 percent rate cap is not rooted in economic reality or necessity. Indeed, the Center for Financial Services Innovation (CFSI) notes, “Concerns about the charging of interest and the amount of interest being charged have deep religious, cultural, and legal roots.”

Moreover, the math simply does not work: A 36 percent rate cap does not allow a margin of profit. Consequently, where a 36 percent rate cap is implemented, credit deserts appear.

Today, what is called “interest” for purposes of a 36 percent rate cap includes items that Ham would not have included, such as fees charged to cover the cost of doing business—paying employees, the cost of capital, and the cost of bad debts, for example. A $15 fee on a $100 loan returns a $1.11 pretax profit; a 36 percent interest rate on the same loan results in a loss of $12.51.

The practical result of a 36 percent cap—the creation of credit “deserts”—stands in opposition to the overwhelming agreement among voters that everyone has a right to access credit.

Some states have passed interest rate caps through the initiative process. The unfortunate situation is that most voters do not understand the math behind interest rates, and a 36 percent cap sounds good superficially. People pushing ballot initiatives do not bear the burden of transparency, because initiatives are ultimately political exercises, not educational ones. If voters were fully informed, they likely would not vote to ban subprime borrowers from having access to credit.

Equally unfortunate in some states, legislatures and governors have passed interest rate caps under similarly naive but well-meaning circumstances.

In either case, the bottom line is that interest rate caps exist in several regressive, non-innovative states.

Illinois provides an excellent lesson on the negative effects of interest rate caps on consumers.