Congress is taking aim at high-rate, short-term lenders in the U.S.
Representatives Matt Cartwright and Steve Cohn are joining forces with Senators Dick Durbin, Barbara Boxer, Richard Blumenthal, Jeff Merkley and Sheldon Whitehouse to establish a national usury limit for consumer credit transactions.
Their targets are banks and finance companies that market payday- and account-advance loans. Many view these loan products to be predatory because of the rates and fees the companies charge and because they’re designed to encourage consumers to re-borrow the funds over and over again.
Advance-type loans are, in effect, cash-flow accelerators: Money that would find its way into the consumer’s checking account in a week or two in the normal course is borrowed and repaid when the deposit actually comes to pass.
Therein lays the problem. By accelerating (moving forward) the cash-receipt date, the consumer creates a cash-flow hole later on. In other words, instead of waiting a week or two for the next payroll deposit, the consumer will have to wait an additional week or two beyond that point.
Then there’s the matter of how these loans are priced.
Short-term lenders often employ a split-pricing approach: one part interest to three, four or five parts fee. But because the loan amounts are typically modest in size—a few hundred dollars or so—the damage feels slight. That is, until you calculate its annual percentage rate.
Apart from the obvious reason (marketing) a company would choose to present its remuneration with split-pricing, the tactic may also be used by non-regulated lenders to skirt statutory usury limits and regulatory scrutiny.
Some states exclusively define usury in terms of interest rate, while others take an APR approach of combining rates and fees into a single metric. Depending on where the non-regulated lender sets up shop, the play between rates and fees can be all over the map, so to speak.
Reps. Cartwright and Cohen and their Senate colleagues hope to change all that.
Is This the Solution?
The prospective legislation proposes to leverage a 2006 law that limits interest rates for military members and their families into one that covers other types of consumer credit products as well. The 36% rate they have in mind is APR-based. It’s also roughly equal to the APR of a credit card cash advance that’s paid off within a year.
That’s why this idea may be a non-starter.
Advance-type loans are, by definition, very short-term in duration: one to three months at most. As I mentioned, they’re also typically for small loan values. The dilemma is this: lenders need to earn enough to cover the costs they incur to process and administer these loans, plus a profit to make it all worthwhile. The gross profit of a one-month loan for $500 that charges 36% APR is $15. There’s no way to make that pay, regardless of the size of the firm or the volume of its business—not when credit bureau reports alone can run as much as $10 a pop.
What’s more, it appears that the legislation also proposes to incorporate late fees and nonsufficient funds (bounced check) charges into the baseline APR calculation. If that’s the case, it’s time to call it quits. Although we can argue about limiting the values of these penalties, lenders incur real costs to collect past-due payments and they’re also charged NSF fees by their banks when the checks they deposit fail to clear. I am, however, curious why some of these fees are excluded from the APR calculation for loans that exceed three months’ duration. Fees that are forced to amortize over a month or two have a much greater impact on APRs than for those that can be apportioned over longer periods.
Speaking of APRs, I’m concerned that the prospective limit isn’t linked to a financial index. Interest rates are constantly in motion and even though they’ve been stuck on the low end of the scale for some time now, that won’t always be the case.
I’m also worried that the legislation doesn’t cap the size of the consumer loan that would be affected by it. For example, a five-year car loan that charges 36% will cost consumers more in interest over its life than the amount that was originally borrowed. Advance-type loans are one thing because of their relatively small dollar values, but larger loans are something else entirely.
Last, I’m disappointed that the prospective legislation targets only consumer loans. There has been a veritable explosion of alternative finance lenders offering comparably-priced advance-type loans to small businesses as well. Don’t those companies deserve the same level of protection? After all, small businesses are nothing more than consumers who are self-employed.
My hope is that Congress and the regulators will arrive at a more sensible, enduring and implementable solution. High-rate, advance-type loans have the potential to wreak financial havoc on those who can least afford it. The key is to strike a balance between the returns the lenders legitimately need to justify their efforts and what their customers can reasonably expect to pay back.
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This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.