Are state interest-rate caps an automatic win for borrowers?

Annie Millerbernd, NerdWallet

Small-dollar, short-term lenders, unburdened by a federal maximum interest rate, can charge borrowers rates of 400% or more for their loans.

But more states are bringing that number down by setting rate caps to curb high-interest lending. Currently, 18 states and Washington, D.C. , have laws that limit short-term loan rates to 36% or lower, according to the Center for Responsible Lending. Other states are weighing similar legislation.

“This legislative session we’ve seen an increased and renewed interest in limiting interest rates and limiting the harms of payday loans,” says Lisa Stifler, director of state policy for the CRL.

Rate-cap opponents say that when a state caps interest, lenders can no longer operate profitably, and consumers with already limited options lose their last resort. Consumer advocates say that caps free borrowers from predatory lending models.

Here’s what happens when a state caps interest rates and what alternatives consumers have for small-dollar loans.

LEGISLATION TARGETS APR

To deter high-interest lenders and protect consumers against predatory loans, legislation targets the somewhat complex and decidedly unsexy annual percentage rate.

APR is an interest rate plus any fees a lender charges. A $300 loan repaid in two weeks with a $45 fee would have a 391% APR. The same loan with an APR reduced to 36% would have a roughly $4.25 fee — and much less revenue for the lender.

APR isn’t an appropriate way to view the cost of a small loan, says Andrew Duke, executive director of the Online Lenders Alliance, which represents short-term online lenders.

“The number ends up looking a lot higher and more dramatic than what the consumer perceives to be the cost of the loan,” he says.

Duke says consumers should instead use the actual fee to assess a loan’s affordability.

But what the fee doesn’t show is the costly, long-term debt cycle many borrowers end up in, Stifler says.

More than 80% of payday loans are taken out within two weeks of repaying a previous payday loan, according to the Consumer Financial Protection Bureau.

“The business model of payday loans and the industry is based on repeat borrowing,” Stifler says. “It is a product that causes a debt trap that actually pushes people out of the financial system.”

In states that don’t allow interest rates above 36% or otherwise ban payday lending, there are no storefront payday lenders, according to the Pew Charitable Trusts.

CONSUMERS HAVE OTHER OPTIONS

Some high-interest loans, like pawn loans , may remain after a rate cap is implemented, Duke says, but limiting consumers’ options could force them to miss bill payments or incur late fees.

Illinois State Sen. Jacqueline Collins, D-Chicago , who was a chief co-sponsor on the consumer loan rate cap in Illinois that was signed into law in March , says she hopes that the new law will remove the distraction of payday and other high-interest loans and give the state’s residents a clearer view of affordable alternatives.

Credit unions, for example, can offer small loans. While credit scores are considered on a loan application, a credit union often has a history with a borrower and can assess their ability to repay the loan using other information. This can make it easier to qualify.

For consumers struggling to pay bills, Stifler suggests contacting creditors and service providers for a payment extension. She recommends consumers turn to credit counseling agencies, which can offer free or inexpensive financial assistance , or religious organizations, which can help provide food, clothing and help with transportation to a job interview .

Exodus Lending is a Minnesota nonprofit that advocates for fair lending laws and refinances residents’ high-interest loans with interest-free ones.

Many people who come to Exodus for help say they chose a high-interest loan because they felt too ashamed to ask a friend or family member for help, says Executive Director Sara Nelson-Pallmeyer . If Minnesota caps interest rates on short-term, small loans — which a bill on hold in the legislature aims to do — she says she’s not worried about how consumers will fare.

“They’re going to do what people do in states where they aren’t allowed,” she says. “Borrow from people you care about, ask for more hours, take on a second job, sell your plasma — just the things that people do who don’t go to payday lenders, and that’s most people.”