Senator Bernie Sanders and Representative Alexandria Ocasio-Cortez want to cap consumer interest rates in an effort to reduce “exorbitant” credit card fees and other forms of predatory loans.
Sanders and Ocasio-Cortez should rethink their proposal or risk emboldening the type of loan they hope to eliminate.
While that sounds good in principle, in practice their plan would hurt some of the people it is meant to help by killing an industry vital to struggling households: short-term loans and small dollars.
The history of small loans and their regulation, which I explore in a recently published book– shows why Sanders and Ocasio-Cortez should rethink their proposal or risk emboldening the kind of loan they hope to eliminate. Part of the reason is that their plan is based on a simplistic history of rules that limit usury or the amount of interest lenders can charge.
A brief history of usury
Usury laws are a old idea. Religious texts such as the Bible and the Koran prohibited any form of usury, while the Romans prohibited charging compound interest.
And when the first American settlers began to settle along the east coast, they brought with them The English Usury Act. In the 1970s all states except three still had general usury laws on the book. Annual rate caps ranged from as low as four percent in North Dakota to as much as 30 percent in Rhode Island.
These caps became less effective in 1978 when the United States Supreme Court has ruled that state laws do not apply to loans from out-of-state banks. This has allowed credit card-issuing banks to avoid more stringent usury laws by locating in states with higher limits or none. Some states, like South Dakota and Delaware, repealed their laws after the ruling to attract banks.
From the turn of the 20th century, states began to make exceptions to their usury laws to allow small loans.
So while usury laws still generally restricted the rates of certain types of loans, the sky became the limit for bank-issued credit cards, with some charging subprime rates as high as 79.9 percent per year.
Sanders and Ocasio-Cortez would love to go back to the world as it was before what they call it Supreme Court decision “disastrous”. Their Usurers Prevention Act would impose a 15% annual interest rate cap on all consumer loans while allowing states to set rates even lower.
But their understanding of history is not entirely correct. This is because from the turn of the 20th century, states began to make exceptions to their usury laws to allow small loans.
Small Loan Laws
By the turn of the 20th century, state usury laws applied to almost all types of loans. As a result, small dollar loans have been effectively prohibited almost everywhere because lenders could not operate profitably at statutory charging rates.
Usury laws set maximum fees as a percentage of the amount borrowed on an annual basis, resulting in minimal dollar fees for small, short-term loans. For example, in a state with a cap of 6%, a lender offering a loan of US $ 200 over three months could only charge $ 3 total interest, the monthly rate would be only 0.5%. At such low rates, low-value lenders could not cover the costs of running their business.
Working-class households still needed access to credit, so strict usury laws did not diminish the demand for these loans.
But working-class households still needed access to credit, so strict usury laws did not decrease demand for these loans. Price caps have simply discouraged legitimate businesses from entering the market. This left borrowers struggling with loan sharks willing to break the law.
The Russell Sage Philanthropic Foundation, who studied the problem in the 1910s, urged states to exempt small money approved lenders from their general usury laws. The foundation drafted a model law, known as the Uniform Small Loans Act, which allowed these lenders to charge up to 3% per month, or 36% on an annualized basis, on cash loans of a few. hundreds of dollars.
Today, the 50 states continue to allow low-value lenders to charge more than 15% per annum.
A return of the shark?
I think Sanders and Ocasio-Cortez are right to be concerned about the high fees and charges on credit cards.
But the Usurers Prevention Act, as it is written, would take us not just to 1978, but to the late 19th century when low-income Americans in need of short-term loans were at the mercy of loan sharks. Traditional installment lenders and other short-term, small-sum credit providers would be billed out.
Limiting the charge rate to 15% per annum will not make these loans cheaper.
This is because a rate cap that works for large, long-term loans will not work for smaller, shorter-term loans. Only a charity or government-subsidized lender, such as a Postal bank, could offer small amount short term loans at a rate of 15% per annum and make ends meet.
Millions of consumers across the country depend on access to small loans. Limiting the charge rate to 15% per annum will not make these loans cheaper. It will simply do away with the law-abiding industry, leaving more borrowers at the mercy of loan sharks.