For centuries, rulers and lawmakers have imposed interest rate caps. These caps likely stem from the widely held belief that caps make loans cheaper for necessitous individuals. This belief persists today. But suppose the belief is wrong?
Economic theory predicts that interest rate caps make loans less available to subprime borrowers. My colleagues, Gregory Elliehausen and J. Brandon Bolen, and I
We chose Missouri because it does not have a legislated interest rate cap and lets a competitive market determine interest rates. By contrast, in March 2021, Illinois imposed an all-in annual percentage rate (APR) cap of 36%. This law covers loans under $40,000 from nonbank and non-credit-union lenders.
Using credit bureau data, we found three significant changes in Illinois during the six months following the imposition of the 36% interest rate cap. First, the number of unsecured installment loans to subprime borrowers decreased by 34,052. This change is a 44% decrease from the level predicted if the growth in Illinois loans paralleled the loan growth in Missouri.
Second, by contrast, the number of unsecured installment loans in Illinois to prime borrowers after the 36% interest rate cap imposition increased by 20% to 19,238. Third, the average loan size for subprime borrowers in Illinois increased by about 40% following the imposition of the interest rate cap. The average loan size for prime borrowers only increased by 7%.
Although banks and credit unions are exempt under the Illinois law, they did not materially increase the number of loans they made to subprime borrowers in the six months following the imposition of the 36% interest rate cap. Thus, subprime borrowers were not able to replace the loans they lost that were made by finance companies.
What were the self-reported effects on subprime borrowers in Illinois? An online survey of small-dollar credit customers in Illinois was conducted about nine months after the imposition of the Illinois rate cap. Nearly 80% of respondents answered that they would like the option to return to their previous lender, and more than 90% indicated that their previous loan had helped them manage their financial situation at the time of the loan.
Most respondents reported being unable to borrow money (presumably from any source) when they needed it and could not pay one or more bills since March 2021. Further, nearly 40% of all respondents — and nearly 50% of minority and low-income respondents — answered that their financial well-being declined. Thus, the Illinois interest rate cap of 36% likely worsened many consumers' economic well-being.
Binding interest rate caps create loan deserts for some loan amounts — there is demand but no supply. Small-dollar loans require a high interest to generate the revenue needed to cover the considerable fixed costs for originating, servicing and collecting these loans. A larger loan size might come with a lower annualized interest rate, but the borrower has more debt, and likely, a higher monthly payment — resulting in more interest paid.
People who make regulatory decisions on behalf of borrowers are likely well intentioned, but many do not understand how small-dollar installment loans can help borrowers who face difficult financial circumstances. In Illinois, we found that the immediate effect of a 36% interest rate cap was to deny much-needed credit. Academic research like this study is essential for creating well-informed and effective regulation. Responsible lawmakers must fully understand and accept that their actions have consequences for consumers.
