The small-dollar loan landscape contains many credit products. This landscape is diverse because consumers have diverse needs and a range of credit scores. Understanding the full range of small-dollar loan products and the differences among them is critical for anyone who regulates or advocates along this landscape.
Without an understanding of the different products, it's easy for regulators — however well-intentioned — to make products more expensive for consumers.
For example, there are differences between a lump-sum payday loan and a relatively new product, best described as a "payday installment" loan. With the former, a consumer repays the entire loan at one time; with the second, the consumer repays the loan with equal payments over time. In addition to these two, there is a clearly different product: a traditional installment loan from a finance company.
What makes traditional installment loans different from payday installment loans? The most important difference is that lenders who make traditional installment loans "underwrite" their loans. That is, they consult with consumers and examine the potential borrower's cash inflows and outflows. In this way, traditional installment lenders predict whether borrowers can afford the payments.
Not all borrowers can. As a result, traditional installment lenders turn down anywhere from 40% to 60% of the applicants for their loans. These disappointed applicants still have a demand for credit, so they must fulfill it in other ways.
Lump-sum payday lenders and payday installment lenders fill an important niche along the small-dollar loan landscape. The demand for credit exists for almost all consumers — some of them with low incomes, low levels of savings and damaged credit. Lenders who make loans to these consumers are taking a high risk that the consumer cannot pay them back. To afford making loans to this set of consumers, the interest received from the loans that are paid back has to cover the costs of the loans that consumers do not pay back.
Different sets of regulations govern payday installment lenders, vs. traditional installment lenders. Payday installment lenders generally operate under exemptions to state laws governing allowable loan fees. Traditional installment lenders generally operate under vestiges of the Uniform Small Loan Law of 1916 — a model law that founded the small-dollar installment loan industry.
With a 12-month, $2,000 payday installment loan carrying a 300% annual percentage rate (APR), the monthly payment is $537. This monthly payment is more than double the $265 monthly payment on a similar traditional installment loan with a 96% APR. Consumers who qualify for the traditional installment loan would surely choose to take out this lower cost loan.
Why don't consumers use more traditional installment loans? The answer is that three-fourths of the states impose a 36% (or lower) rate cap on traditional installment lenders. The lender cannot cover costs for many loan sizes under a 36% rate cap, including loans for $2,000. So the 36% rate cap creates a "credit desert" for many loan sizes. When the rate cap sidelines traditional installment loans, consumers end up paying more for other kinds of loans.
Rather than setting arbitrary caps on important financial products, regulators should focus on creating a level playing field, preventing fraud, and setting policies to increase competition. One guaranteed way to increase competition along the small-dollar loan landscape it to remove, or dramatically increase, rate caps on traditional installment loans.
The common 36% rate cap has remained unchanged in the 100 years since the advent of this industry — which was created through a cooperative effort among reformers, advocates, and legitimate lenders who all wanted to combat illegal "loan sharks." It is long past time for state legislatures to revisit rate caps of small-dollar traditional installment loans. Raising rate caps will help — not hurt — consumers by increasing their borrowing options.
Consumers benefit greatly from increased competition in any market, especially a credit market.