Protecting Americans from predatory banking practices is certainly a noble goal. Unfortunately, politicians who pursue it have a tendency to miss the bigger picture. Short-sighted measures designed to punish the “big banks” might lead to some good headlines or a small polling bump, but in many cases, they also end up hurting the very people they were supposed to help.
It’s important to consider how these policies would affect the most vulnerable Americans, especially in times of crisis. A Federal Reserve study found that only 63% of American households said they could cover a $400 emergency expense, like a medical bill or car repair, by paying it in cash, pulling from savings, or putting it on a credit card and paying it off the same month. The remaining 37% would have to get more creative.
For these vulnerable households, the most common strategy (chosen by 15% of respondents) was to put the expense on a credit card and pay it down gradually. At current rates of around 29%, a $400 balance would rack up about $10 a month in interest. That’s an annoyance, but it’s a lot better than losing access to a drivable car or having a bill sent to collections. And once the short-term pressure is off, the family can start making payments—$50 here, $20 there—until they’re back on an even keel.
What happens, though, if the family can’t get a credit card? That’s a very real possibility if lawmakers succeed in capping interest rates — which, unfortunately, is exactly what they’re trying to do.
In early March, lawmakers introduced legislation that would ban credit card companies from charging interest rates higher than 10%.
The problem with these simplistic complaints against “high” interest rates is that credit card companies set interest rates based on the level of risk they assume. If Congress imposes an artificial ceiling on how much interest they can charge, their only option will be to reduce risk by denying credit cards to people in financially precarious situations.
In one stroke, well-meaning politicians could eliminate the number one option for poor families facing a financial emergency.
For the approximately 40 million American adults who have a checking account but no credit card, another method of dealing with a surprise $400 bill is to overdraw their account. This incurs a flat overdraft fee (usually after a 24-hour grace period), but if a crisis hits three days before payday, taking a $35 hit might be the least of that family’s worries.
Once again, though, policymakers seeking to protect the vulnerable risk pulling away one of their most important lifelines.
In the final weeks of the Biden administration, it promulgated a rule capping overdraft fees at $5 (though U.S. Senate Republicans voted to overturn it on March 27). This seems like a compassionate policy, but it’s important to look at the unintended consequences.
According to a 2021 report from the Federal Reserve Bank of New York, banks subject to overdraft fee caps “reduce overdraft coverage”—meaning they simply decline the transactions—“causing more returned checks and a decline in account ownership among low-income households.”
The same impoverished family that won’t be able to get a credit card if lawmakers cap interest rates won’t be able to overdraw their account either if the CFPB rule remains in place. So how do they deal with that $400 surprise?
One especially pernicious possibility is taking out a payday loan. The average interest rate on a payday loan is almost 400%, and 80% of those loans aren’t repaid within the typical two-week window. Around 12 million Americans take out payday loans every year, a number that could skyrocket if caps on interest rates and overdraft fees remove other options for those who need them most. Nobody facing financial hardship enjoys paying credit card interest or overdraft fees. But when the alternative is watching a $400 debt double (or triple) after just a few months, $35 overdraft charges and 29% interest rates suddenly look like a pretty good deal.
This is the most important lesson in public policy: everything affects everything else. If you’re a fan of simple, unambiguous resolutions, read a fantasy novel; don’t go into politics. Because when lawmakers and regulators take a naïve approach to complex problems, they risk pulling their fellow citizens out of the frying pan only to cast them into the fire.
