What’s more expensive for consumers with poor credit—the daily cost of a short-term loan or an overdraft fee? The answer may surprise you.
Short Term Loans continue to receive a bad rap in American political discourse and are routinely viewed as such predatory by lawmakers who think they are unfairly targeting low-income Americans. These federal and state lawmakers argue that short-term lenders are taking advantage of vulnerable Americans by offering high-interest loans that they cannot afford to pay back. Therefore, they conclude that strong consumer protections are needed to curb these unsavory business practices. Oddly enough, these same lawmakers often have little to say about overdraft fees and a much greater burden on consumers.
in the last decade, 19 states have enacted laws and regulations that impose interest rate caps on small loans. The pressure to act is also growing at the federal level. Several senators in the past year suggested a law capping the APR for short-term loans at 36 percent and effectively banning all loans with an interest rate higher than 36 percent.
Such a proposal, if implemented, would prove devastating for short-term lenders who rely on the ability to adjust interest rates to protect them from high-risk consumers. research suggests that high interest rates are often required to recoup the cost of defaulting and reap even the smallest of profits. The loss of this flexibility has repeatedly led to companies in states like Illinoiswhere a 36 percent tax ceiling has been set.
A national interest rate cap would be even more damaging to consumers. This is because the 12 million Americansor 5.5 percent of the population who use short-term credit are more likely to be unbanked or underbanked. These Americans either do not have access to credit from traditional financial institutions or have limited access to credit from other lenders. Either way, these Americans rely on alternative forms of credit available only from short-term lenders.
Therefore, an arbitrary cap of 36 percent APR would adversely affect these Americans.
In contrast to the strict regulations imposed on short-term lenders, many large banks face few restrictions on their for-profit practices overdraft fees. Overdraft fees, imposed by the bank on customers who withdraw more money from their accounts than they have, are an important source of revenue for banks. According to the Consumer Protection Bureau, overdraft fees and insufficient fee income account for “nearly two-thirds of reported fee income.” In 2021, consumers paid more than 8 billion dollars for overdraft fees.
Unfortunately loud federal reserve, these earnings are often collected from Americans, who are more likely to be “lower-income adults, less-educated adults, and black and Hispanic adults.” In fact, research from the CFPB found that “8 percent of customers pay nearly 75 percent of all overdraft fees,” meaning those Americans who can least afford to pay them are responsible for a disproportionate share of overdrafts.
A quick comparison between a typical short-term loan and a standard overdraft fee illustrates how absurd it is to focus on strict interest rate caps for payday lenders when banks continue to charge high overdraft fees.
For example, a 36 percent APR cap on a two-week $200 loan results in a consumer fee of just 0.6 percent per day on the loan. In contrast, A is number of large banks charge an overdraft fee of $36, which is an effective interest rate of 18 percent for one day. In summary, we see a short-term loan at 36 percent APR and an overdraft fee at 915 percent APR.
This example shows the huge discrepancy between a typical short-term loan and a typical overdraft fee. Still, lawmakers seem intent on disproportionately scrutinizing payday lenders and denying high-risk consumers access to short-term credit.
In fact, according to a 2016 report According to the Tarrance Group polling firm, 96 percent of borrowers said “the payday loans they took out were personally useful to them.” Additionally, a 2020 Morning Consult opinion poll found that a strong majority of Americans believe that the “amount lenders should charge for a $100 two-week loan” should exceed the 36 percent cap proposed by Congress.
The reality is that payday lenders are providing a valuable service to unbanked and unbanked Americans, and lawmakers are threatening to take it away. Americans who would not otherwise be eligible for a line of credit, many of them low-income and people of color, can do so with a small loan. This small loan can be anything that stands in the way of a family paying their next month’s rent or being evicted.
Legislators should resist the urge to impose payday loan caps that only penalize the very people the law was intended to help. Such a regressive law would almost certainly lead consumers to choose alternative, far riskier forms of credit like Shady’s loan sharks and pawnshops.
Instead, lawmakers should focus on the big banks, which continue to enrich themselves at the expense of their poorest customers. It’s overdraft fees, not payday loans, that penalize low-income Americans for not having enough money in their bank accounts. And those are consistent overdraft fees Price people out of banking.
