Imposing rate caps implies that if you can’t get access to credit from a bank, you don’t deserve it. We disagree.
Loans with high APRs (Annual Percentage Rates) have come under fire by lawmakers and advocates pushing for increased regulation in the short-term lending industry. We’ll put aside that APRs aren’t the best way to understand these loans since they are usually two weeks to a month long, rather than a year or multiple years in duration.
Do Capping APRs Protect Borrowers?
Proposals have sprung up to cap APRs as a means of protecting borrowers. While we believe in the goal of creating a safe landscape for borrowers, this approach will inevitably squeeze the riskiest borrowers out of the lending market completely and reduce access to credit for many others.
These types of proposals are being debated at the state and federal levels. In South Dakota, for example, state representatives are considering whether to join the 17 other states that have capped interest rates on short-term loans loans . Nationally, Representatives Matt Cartwright (PA) and Steve Cohen (TN) introduced legislation in July to enact a cap on consumer credit products, such as payday loans.
For some advocates, rate caps are the logical answer to affordable credit. But here’s the problem. In a competitive market, interest rates are a function of risk. They also reflect the costs of acquiring and servicing customers, but the biggest driver of what interest rates customers receive is how risky their lender deems them to be. As any lender decides whom they will approve, they are balancing both the risk of saying no to a customer who is a good risk and losing revenue and saying yes to a customer who is a poor risk and not getting paid back. The level of risk a lender chooses to take on is reflected by the interest it charges.
Why Don't Banks Make These Loans?
Most banks are limited to charging 36% APR. For a borrower who needs just a few hundred dollars for an unexpected emergency until their next payday, the economics don't make sense – there are high compliance costs, high overhead costs, and lenders have very little information about borrowers’ credit history who are thus deemed “high risk”.
Alternatively, payday lenders have more flexibility (and probably desire) to serve the needs of this community and can assume higher risk by charging higher rates (though lower rates than bank overdraft fees in many cases). Advocates for rate caps want to artificially limit how high those rates can be, which inherently means two things - fewer people can be approved for loans or the lender has to lend higher dollar amounts to cover the revenue needed to make the loan profitable – thus forcing more tempting debt, and required fees, onto a consumer. Consumer protection can’t simply mean denying borrowers access to credit; since the need for credit will still exist, these caps just push borrowers further away from the financial services mainstream or further into debt.
The Impact of an APR Cap on LendUp Customers
To understand the potenial impact of a nation-wide rate cap on LendUp borrowers, we looked at revenue and expenses related to first-time LendUp customers in California in December. We calculated how many fewer customers LendUp would have had to approve in order to break even at various rate cap thresholds. The chart below displays these results:
The results are clear. Rate caps would force us to decline far more applicants, leaving them with fewer options, or even forcing them to turn to unlicensed lenders. Keep in mind, this doesn’t even account for overhead expenses like rent, insurance, or employee salaries.
One of LendUp’s constraints is that its business model is different than a lot of its competition. LendUp doesn’t charge borrowers late fees and the concept of “rollover” interest rates is nonexistent. Because of these practices, LendUp relies on interest revenue to compensate for the losses incurred from borrowers who default. As borrowers demonstrate good borrowing behavior over time, they receive lower and lower interest rates as they prove to be less risky. Over time, LendUp borrowers can gain access to rates lower than even some bank loans or credit cards. This is the essence of the LendUp ladder—rewarding good payment behavior with better terms and the opportunity to build credit.
It’s also important to compare these rates to banks. For a first-time LendUp customer in California to borrow $250 over a 30 day period, the total interest is $43, which translates into a 210% APR (if that 30 day loan were renewed each month for 12 months). LendUp borrowers can then work their way up the ladder to APRs as low as 29%.
Putting Rates in Perspective
You may be thinking, “Okay, but a 210% APR still sounds unnecessarily high.” Let’s put this into perspective by looking at the APR of a subprime credit card targeted to a similar customer demographic. An unnamed subprime credit card issuer currently offers a credit card that has an APR of 36%, a setup fee of $95, an annual fee of $75, and a $300 credit limit.
Because annual fees and monthly fees for credit cards are not included in the calculation of the APR, customers are getting a product with $300 line and an upfront cost of $170 plus 36% APR on credit utilized. Thus the cost to access the first $130 in credit is $170 plus 36% APR. By comparison, the same person can borrow $130 from LendUp for two weeks for $17.48, but that computes to an APR of 350%.
Regulations to cap interest rates are designed with good intentions—to protect borrowers from expensive credit. However, interest rate caps actually limit credit access for many borrowers in need. Let’s change the way we think about “fixing” expensive credit. Instead of continuing to talk about potentially misleading triple digit interest rates, let’s talk about finding credit solutions for the millions of under-banked Americans and creating a path for them to gain or regain access to the financial mainstream and build their credit. Regulation to address the deceptive practices within financial services, such as hidden fees, debt traps, and confusing terms, would be a better place to focus.