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Senator Bernie Sanders and House of Representatives member Alexandria Ocasio-Cortez made some news earlier in May with the introduction of the “Loan Shark Prevention Act”, a new policy proposal they co-wrote, and which Senator Sanders has introduced in the Senate (where it is unlikely to gain much traction to move towards a vote). The bill text can be found here, and you’re not missing anything – it only takes up 2 pages, as the proposal itself is both simple, and is also simply an extension/revision of the existing Truth in Lending Act to add a new sub-section, so it doesn’t require a couple of thousand pages like some recent examples of “major” legislation did.
The basics of the proposal is to set a national maximum interest rate of 15%. Since this proposal would build on the Truth in Lending Act, which defines “Annual Percentage Rate” (APR) and what types of fees, in addition to standard interest charges, need to be included in determining the APR. So while an easy way to get around it would be to charge 15% interest in addition to substantial fees, that won’t work: the 15% cap would be calculated in the same way as an APR today, and would include most origination fees.
Like any other credit product, credit card interest rates are based, at least in part, on the credit risk of the cardholder. If banks and card issuers are forced to reduce rates, they will review the risk profile of their customers and could cancel the card or reduce the credit limit of those cardholders who no longer meet their requirements. Those with excellent credit will likely continue to have their cards and their credit limits without change. But those with blemished credit histories may find that they don’t have as much credit available any more, and it will become tougher to get approved for a new card to replace any card cancellations or spending limit reduction actions they suffer. If it becomes harder to get approved for a credit card because of the rate cap, credit card companies may move to offering more secured credit cards (described here), so that the risk is reduced by having a security deposit from the cardholder, or there may be new or higher fees charged to make up for the interest income that is no longer earned.
Another financial product that will change dramatically if this national 15% rate cap went into effect is unsecured personal loans – including payday loans, installment loans, and cash advance services. Installment loans for prime customers won’t be affected too much – while these loans have rates above secured loans (such as mortgages and auto loans) – the rates for prime customers are generally in the 6% to 10% range. In fact a common use of a personal loan is to use the loan proceeds to pay down outstanding credit card balances, since those rates tend to be higher than the rate on the loan. However, for sub-prime customers, who have fewer options and usually don’t qualify for a personal loan from a bank or credit union, the installment loan rates can be much higher.
As a basic example, if there was a cash advance business that charged $15 for every $100 borrowed, and the payment was due 2 weeks later (the total payment would be $115, so $15 would be the finance charge), the APR would be 390%. This is because there are 52 weeks in the year, so 52 / 2 = 26, and 26 x 15% = 390%. To make this business comply with the proposed 15% APR cap, one change would be to allow borrowers to make the payment after 1 month instead of 2 weeks. Of course, we’d also need to reduce the fee payment as well. In this case, the fee per $100 borrowed could be 15% / 12 months = 1.25%. So that means that this cash advance business would need to change it’s fees to $1.25 per $100, and provide the borrower a full month to make the payment. So the borrower could come in on the 20th of the month, get $100 with a promise to make a payment of $101.25 on the 20th of the next month. Likely, having a gross profit of $1.25 wouldn’t be sufficient, so they’d increase the minimum cash advance amount. Possibly they increase it to $400, AND they also lengthen the time so the borrower gets 2 months to make the payment. In this case the customer borrows $400 and still only needs to bring in $410 two months from now.
There’s a lot of risk for the business that they customer won’t show up with the money, and this type of business would have rent, wages, utilities, furniture and equipment, office supplies, health insurance, and all the usual expenses of a small retail business. Let’s say the owner determines that the business needs to have $12,500 per month in fee revenue to make it worth it – paying all the business expenses, and then paying the proprietor a fair amount for his/her efforts too. That’s $150,000 annually, and it means the business needs to make $1,000,000 worth of cash advances per month on average. If the average advance is $500, then that’s 2,000 customers per month, which is 100 per day if the owner opens up the shop 20 days each month (equivalent to every Monday-Friday excluding 10 holidays and 2 weeks of vacation per year). But then there’s two major expenses we didn’t mention: losses and interest. If just 5% of the people didn’t make their payment then there’s $50,000 of principal that is lost, plus $7,500 in fee income not earned – $57,500 total. The losses on sub-prime lending tend to be much higher, easily enough to wipe out the entire $150,000 worth of fees. However, if losses were limited, then we still have to account for the interest payments – the business is lending $1,000,000 per month, on average, to earn this fee revenue. If the proprietor already had $1,000,000 they likely wouldn’t bother to run the business, so they are presumably using business financing to get it. If they have a 6% interest rate, that’s 0.5% per month – $5,000 per month, or $60,000 annually in interest expense. Other retail businesses do deal with shrinkage (loss), and with interest or finance charges to acquire inventory to sell. The difference is that these businesses aren’t limited to a markup of 15% by law.
So, the reader can determine for him/herself if this updated cash advance/payday loan business seems viable. It does seem that any existing business in this space would end up chasing its tail – constantly needing more loans to drive more fee revenue, but knowing that around 2/3rd of the fee revenue is going directly to loss reserves and interest expense, with more direct costs (like more agents) also tied to increased revenue. Even the assumption above: 100 customers every day on a business that can operate for under $12,500 per month means that there are only a couple of agents bringing in around an average wage and each agent can handle a customer completely in under 10 minutes. This seems unlikely to hold up in real life – either they will need more agents and won’t be able to afford to pay them each even average wages (or there are minimal benefits offered), or more likely, the business would require more revenue to be viable. If the revenue increase is forbidden by law, then the only choice will be going out of business. This won’t affect the majority of people that have access to lower cost financing and don’t have a need. For those that do use these cash advances today they will need to find alternatives – some won’t be legal – or they will potentially have short-term emergencies turn into long-term financial issues when car payments, utility bills, or even the rent or mortgage don’t get paid.