By Annie Millerbernd | NerdWallet
Small dollar short-term lenders who are not burdened by a federal rate limit can charge borrowers interest rates of 400% or more on their loans.
But more states are lowering that number by setting interest rate caps to curb high-interest borrowing. For now, 18 states and Washington, DC, have laws that limit short-term lending rates to 36% or less, according to the Center for Responsible Lending. Other states are considering similar laws.
“During this term we have seen growing and renewed interest in capping interest rates and capping the damage of payday loans,” said Lisa Stifler, director of government for the CRL.
Opponents of interest rate caps say that if a state caps interest rates, lenders can no longer operate profitably and consumers with already limited options lose their last resort. Consumer advocates say borrowers will be freed from predatory loan models.
Here’s what happens when a state caps interest rates and what alternatives consumers have for small dollar loans.
Legislative goals APR
In order to deter high-interest lenders and protect consumers from overexploitation loans, the legislation is targeting the somewhat complex and downright unsexual APR.
The APR is a rate plus any fees that a lender charges. A $ 300 loan repaid in two weeks with a $ 45 fee would have an APR of 391%. The same loan with an APR cut to 36% would have a fee of about $ 4.25 – and much less revenue for the lender.
APR is not a suitable way to show the cost of a small loan, says Andrew Duke, executive director of the Online Lenders Alliance, which represents short-term online lenders.
“The number ends up looking a lot higher and more dramatic than the consumer perceives the cost of the loan,” he says.
Duke says consumers should instead use the actual fee to assess the affordability of a loan.
What the fee fails to show, however, is the costly, long-term debt cycle that many borrowers end up in, says Stifler.
According to the Consumer Financial Protection Bureau, more than 80% of payday loans are taken out within two weeks of a previous payday loan being repaid.
“The payday loan business model and the industry is based on repeated borrowing,” says Stifler. “It’s a product that creates a debt trap that actually drives people out of the financial system.”
States that don’t allow interest rates above 36% or otherwise prohibit payday loans have no payday lenders, according to the Pew Charitable Trusts.
Consumers have other options
Some high-yielding loans, like pawns, could stay in place after an interest rate cap was put in place, Duke says, but limiting consumer options could force them to miss bill payments or pay late fees.
Illinois Senator Jacqueline Collins, D-Chicago, who was a major co-sponsor of the Illinois consumer credit limit, which was signed in March, hopes the new bill will remove the distraction of payday and other high distractions – Interest rate loans and give the residents of the state a clearer view of affordable alternatives.
Credit unions, for example, can offer small loans. While creditworthiness is taken into account in a loan application, a credit union often has a history with a borrower and can use other information to assess their ability to repay the loan. This can make it easier to qualify for a credit union loan.
For consumers who have difficulty paying bills, Stifler suggests contacting creditors and service providers for a payment extension. She recommends that consumers turn to credit counseling agencies, who can provide free or low-cost financial assistance, or religious organizations who can help with providing food, clothing, and transportation to an interview.
Exodus Lending is a Minnesota nonprofit advocating fair credit laws and refinancing high-interest loans from residents through interest-free loans.
Many people who come to Exodus for help say they chose a high-yield loan because they were ashamed to ask a friend or family member for help, says executive director Sara Nelson-Pallmeyer. With Minnesota capping short-term small loan interest rates – which is what a withheld bill aims to do – it doesn’t worry about how consumers will fare.
âThey will do what people do in states where they are not allowed,â she says. âBorrow from people you care about, ask for more hours, get a second job, sell your plasma – the very things that people who don’t go to payday lenders do, and they are most people.”
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Annie Millerbernd writes for NerdWallet. E-mail: [email protected].