With stubbornly high inflation and growing economic uncertainty, ensuring access to affordable credit could be a lifeline for consumers nationwide. One option available to consumers is short-term installment loans, which offer credit to people who may need support to pay bills or cover unforeseen expenses. In recent years, however, a troubling trend has developed with states restricting access to these financial products under the guise of “consumer protection.”
It’s long been established that government-imposed price controls often fail and end up doing more harm than good. From gasoline to interchange fees, government price setting has never worked, and unfortunately, capping interest rates is simply another example of government exacerbating a problem it is attempting to fix.
That’s the key takeaway from new research that has analyzed new laws from states that recently implemented price controls on interest rates for certain consumer loans. For example, in 2021 Illinois enacted a cap of 36 percent on consumer loans under $40,000 that originate from nonbank and non-credit union lenders. New Mexico followed suit and a similar law went into effect earlier this year.
Now, research from professors at Mississippi College and Mississippi State University confirm what we already know: These caps harm consumers with lower incomes. Their data confirm that once the Illinois law went into effect, short-term loans decreased by eight percent. It's a clear decline, but the drop is particularly staggering among those with subprime credit, where loan originations dropped by 44 percent compared to the prior year.
These are reactions to policy changes that have disproportionately impacted those with lower incomes and are the most vulnerable in Illinois. On a personal level, that means people who didn’t have enough money in their rainy-day fund found themselves unable to get the money they needed. Without this option to turn to, they have had to rely on the unregulated black market or fall behind on their payments — two options that don’t work in favor of consumers.
Even the Illinois study draws that conclusion, writing “economic theory predicts that an interest-rate cap, like any price ceiling, creates shortages, destroys gains from trade, and gives rise to additional search costs.”
Illinois is not the only state to pass legislation that caps the interest rates of short-term loans. A similar piece of progressive legislation went into effect in New Mexico this year. As is often the case, proponents of the New Mexico law maintained that any void in the availability of emergency loans would be filled by banks. Yet a recent exercise from the Southwest Public Policy Institute demonstrated that the major banks require consumers who need these types of specialized emergency products to have a checking account with them for at least six months. And even if those applying for a loan do have an existing relationship with one of these banks, approval is not a guarantee.
The failing of caps on loans is also evidenced from the other original research from our organization, the American Consumer Institute, and the Urban Institute. In our study, we found caps on interest rates ultimately mean borrowers lose access to an essential source of credit they overwhelmingly approve of and support. At the same time, lenders are also harmed by caps on interest rates because their customer base is overwhelmingly composed of high-risk borrowers who are significantly more likely to default on a loan. Similarly, the Urban Institute finds that there are better ways of protecting consumers than instituting a 36 percent rate cap.
The lesson from these real-world examples and academic research is clear: Imposing caps on small-dollar loans harms consumers. In many cases, it pushes them to seek out unsustainable alternatives like borrowing from a family member or, even worse, a loan shark or other source of predatory lending.
At the end of the day, we all recognize that there needs to be a balance between protecting consumers and ensuring we keep credit accessible and affordable. Never mind that consumer lending is one of the most highly regulated industries in the country, with strict consumer protection laws at both the federal and state levels. If policymakers really wanted to protect consumers without limiting their access to credit, they would look at maximizing these laws, not misguided price controls.
Politicians are unfortunately okay with that collateral if it means going after these politically “unsavory” businesses. No doubt the short-term lending industry has found itself in the crosshairs of politicians in their ivory towers, but it is an industry that is a life-saver for when people are most in need of credit. It’s an unfortunate truth that a large number of Americans are unable to cover an unforeseen expense of $400, a fact that is exacerbated by this period of price inflation.
In pressing times, Americans know they can turn to small dollar credit products to bridge the gap between paychecks. Unfortunately, if lawmakers in states, or even in Congress, get their way, Americans may find that they have significantly limited options.
