By Rajashri Chakrabarti, Gabriel Leonard, Donald P. Morgan, Thu Pham, and Lee Seltzer; Federal Reserve Bank of New York/Liberty Street Economics
Click here to read the entire article.
In imperial China, 3 percent was the maximum legal monthly loan rate; charging more was punishable by 40 to 100 blows with the “light cane.” (Rockoff 2003) Centuries later, many U.S. states are imposing the same cap (without corporal penalties) on alternative credit providers, such as payday, installment, and auto-title lenders, with the goal of lowering credit costs and delinquency for the high-risk borrowers that rely on these funding sources.
A concern, however, is that lenders will simply refuse to lend to these borrowers at lower interest rates. Our recent Staff Report studies how interest rate caps have played out in several states that recently adopted them. Using household-level data from a major credit bureau, we find that loan balances for the riskiest borrowers declined substantially relative to counterparts in states without caps. Despite taking on less debt, these borrowers did not experience an improvement in delinquencies.
The Resurgence of Usury Limits
Usury limits have waned over the centuries in the U.S, but their recent resurgence on the consumer side was triggered by payday lenders’ entry into the small dollar loan market in the mid-1990s (Rockoff 2003). In 2007, rates on loans to military staff were capped at 36 percent—marking the first-ever national usury limit in the U.S. A bill currently before Congress, the Predatory Loan Elimination Act, would extend the 36 percent cap across the entire U.S.
Saunders (2021) traces the 36 percent standard back to credit reform in the early 20th century. Concerned that prevailing usury limits were too low, the Russell Sage Foundation promulgated a Uniform Small Loan Law recommending a higher cap of 3.5 percent per month. Thirty-four states raised caps to between 36 and 42 percent over the next few decades (Anderson et al. 2015).
Cheaper Credit…or Less Credit?
Opponents of rate caps predict that they will lower the supply of credit for riskier borrowers rather than drive down the cost of credit. The textbook credit model below illustrates this effect. In this model, lenders separately provide credit for high-risk borrowers (sH) and low-risk borrowers (sL). At market equilibrium, lenders charge high-risk borrowers i, which is higher than what they would charge low-risk borrowers; lenders charge high-risk borrowers a higher interest rate to compensate for higher expected loan losses. However, a usury cap requires lenders to charge no higher than icap for interest, which is lower than the equilibrium rate i. As a result, lenders contract the quantity of loans supplied, as shown.
In fact, if profits from loans to high-risk borrowers don’t cover the fixed cost of providing them, lenders may entirely refuse to make any loans to high-risk borrowers, which is referred to as credit rationing. This is particularly likely as less creditworthy borrowers are also typically more likely to take out relatively small loans.
Note that icap is higher than the equilibrium interest rate for low-risk borrowers, and under standard model assumptions, lending to lower-risk borrowers does not change. However, under certain conditions, the rate cap could also have implications for low-risk borrowers, a situation we examine in the next post in this series.