State Rate Cap Experiments Show Clear Negative Impacts
The results of state experiments with rate caps are clear: These policy ideas hurt consumers by reducing their ability to access credit.
Rate caps limit the interest rates or fees that lenders can charge borrowers for certain types of loans. State governments often impose them to stop perceived “predatory” lending. For example, the Predatory Loan Prevention Act in Illinois, which took effect in March 2021, caps the annual percentage rate (APR) for all consumer loans at 36 percent.
While rate caps may sound like a good idea in theory, they have many unintended and harmful consequences in practice. Recently, Southwest Public Policy Institute President Patrick Brenner took to the field to demonstrate the anti-consumer harms of these policy experiments by attempting to get a short-term loan in his home state of New Mexico, which recently implemented rate caps. Using his own stable financial situation and strong credit score of over 800, he attempted to access a short-term loan through three large banks in Albuquerque, New Mexico. After a short while, these banks denied his applications, demonstrating the harsh reality that even though some claim the short-term loan market is still being serviced in the state, it’s becoming increasingly difficult to access credit.
The hidden consequence of rate caps is that they reduce credit availability for everyone, including subprime borrowers who need it most. Subprime borrowers are those who have low credit scores, limited income, or other factors that make them risky for lenders. They often rely on alternative financial services, such as payday loans, title loans, or installment loans, to meet their urgent and unexpected expenses, like a car breakdown, medical emergency, or home repair.
However, when policymakers impose rate caps, many lenders exit the market or stop serving subprime borrowers because they cannot cover their costs or earn a reasonable profit. In an Illinois study, post-rate cap loans to subprime borrowers decreased by 38 percent.
As former U.S. Sen. Pat Toomey (R-PA), then ranking member of the Senate Banking Committee, argued in 2021 opening statements to a hearing, “When government price controls reduce access to credit, people who need money can only turn to worse alternatives like loan sharks or overdrawing their bank accounts.”
Rate caps also distort the risk pricing and create inefficiencies in the allocation of capital. Pricing of risk is the process of determining the interest rate or fee that reflects the likelihood and severity of default by a borrower. It is essential to ensure lenders are adequately compensated for their risk and that borrowers pay a fair price for their credit.
However, when states mandate rate caps, they artificially lower the interest rates or fees below the market equilibrium. Doing this creates a mismatch between supply and demand, resulting in shortages or surpluses of credit, as can be seen in Arkansas’s 17 percent interest rate cap’s impact on access to credit in interior counties versus border counties.
Clearly, rate caps are not an effective or desirable way to protect consumers from predatory lending practices and high-cost debt traps. They have many harmful downstream effects, such as reducing the availability of credit for subprime borrowers, distorting the pricing of risk, and creating inefficiencies in capital allocation. Consumers can travel to access the necessary credit for emergencies, but rate caps add red tape to the hassle and struggle for subprime borrowers.
Instead of imposing state or federal rate caps in the future, policymakers should consider reducing regulatory burdens on short-term lenders, enabling them to reduce their cost of lending.