By Annie Millerbernd | NerdWallet
Small, short-term lenders, who are not subject to a maximum federal interest rate, can charge borrowers rates of 400% or more for their loans.
But more and more states are reducing that number by setting rate caps to limit high-interest loans. Currently, 18 States and Washington, D.C., have laws that limit short-term lending rates to 36% or less, according to the Center for Responsible Lending. Other states are considering similar legislation.
“This legislative session, we’ve seen increased and renewed interest in limiting interest rates and limiting the harms of payday loans,” said Lisa Stifler, director of state policy for the CRL.
Opponents of rate caps 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 the caps free borrowers from predatory lending models.
Here’s what happens when a state caps interest rates and what alternatives consumers have for small loans.
Legislation targets RPA
To deter high-interest lenders and protect consumers from predatory lending, the legislation targets the somewhat complex and decidedly unsexy annual percentage rate.
The APR is an interest rate plus the fees charged by the lender. A $300 loan paid off in two weeks with a $45 fee would have an APR of 391%. The same loan with an APR reduced to 36% would have fees of around $4.25 – and much less revenue for the lender.
APR is not an appropriate way to visualize the cost of a small loan, says Andrew Duke, executive director of the Alliance of Online Lenders, which represents online short-term lenders.
“The number ends up looking much higher and more dramatic than what the consumer perceives to be the cost of the loan,” he says.
Duke says consumers should instead use actual fees to gauge a loan’s affordability.
But what the fees don’t show is the costly, long-term cycle of debt that many borrowers find themselves in, Stifler says.
More than 80% of payday loans are taken out within two weeks of paying off a previous payday loan, according to the Consumer Financial Protection Bureau.
“The payday lending and industry business model is one of repeat borrowing,” says Stifler. “It’s 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 ban payday loans, there are no payday lenders, according to the Pew Charitable Trusts.
Consumers have other options
Some high-interest loans, like pawnbrokers, may stay after a rate cap is put in place, Duke says, but limiting consumers’ options could force them to miss bill payments or incur late charge.
Illinois State Senator Jacqueline Collins, D-Chicago, who was a lead co-sponsor of the Illinois consumer loan rate cap that was signed into law in March, says She hopes the new law will remove the distraction of payday and other high-interest loans and give state residents a clearer view of affordable alternatives.
Credit unions, for example, can offer small loans. Although credit scores are factored into 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 get a loan from a credit union.
For consumers struggling to pay their bills, Stifler suggests contacting creditors and service providers for a payment extension. She recommends consumers turn to credit counseling agencies, which may offer free or low-cost financial assistance, or religious organizations, which can help provide food, clothing and transportation assistance to get to 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 loans.
Many people who seek help from Exodus say they chose a high-interest loan because they were too ashamed to ask a friend or family member for help, says Executive Director Sara Nelson-Pallmeyer. If Minnesota caps interest rates on small, short-term loans — which a bill pending in the legislature seeks to do — she says she’s not worried about how consumers will will come out.
“They’re going to do what people do in states where they’re not allowed,” she says. “Borrow from people you care about, ask for more hours, take a second job, sell your plasma – what people who don’t go to payday lenders do, and that’s most people.”
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Annie Millerbernd writes for NerdWallet. E-mail: firstname.lastname@example.org.