Senator. Bernie Sanders and Rep. Alexandria Ocasio-Cortez are seeking to limit the interest rate for consumers for the purpose of trying to cut down on “sky high” credit card charges as well as other types of lending that are predatory.
Although it sounds good in theory, in reality, their plans could harm those they’re trying to help by destabilizing an industry that is vital to struggling families, such as short-term, small-dollar loans.
The story of small-dollar loans as well as their rules that I discuss in my recently released book – demonstrates the reasons why Sanders and Ocasio-Cortez need to reconsider their plan or beware of empowering the kind of lending they want to eliminate. This is in part due to the fact that their proposal is based on a sloppy understanding of the regulations that restrict the amount of the interest rate lenders can charge.
The brief background of the usury
Usury laws are an old concept. Religious texts like that of the Bible and Quran prohibit any form of usury, as did the Romans, which prohibited charging compound interest.
As the early American colonists began to settle along the Eastern Seaboard, they brought with them the usury laws of England. In the 1970s, the three states, with the exception of North Dakota, had general regulations regarding usury in force. The annual rate caps varied from as low as 4 percent within North Dakota to as high as 30 percent within Rhode Island.
The caps were weakened in 1978 when it was the U.S. Supreme Court ruled that state laws didn’t apply to loans made by out-of-state banks. The ruling allowed banks that issue credit cards to stay clear of more stringent usury laws by choosing to locate in states with higher caps or none altogether. Some states, including South Dakota and Delaware, had their rules changed following the ruling in order to attract banks.
Although the laws on usury generally restrained rates on certain kinds of loans, the sky was the limit for credit cards issued by banks, with some that charge subprime rates of 79.9 percent per year.
Sanders and Ocasio-Cortez want to see the world of before the “disastrous” Supreme Court decision. Their loan Shark Prevention Act would place the 15% annual interest rate limit on all consumer loans, while states are able to set lower rates.
However, their understanding of historical events isn’t exactly correct. It’s because, from the beginning of the 20th century, states began making exemptions in their laws regarding usury to permit small-sized loans.
Small-sum lending laws
In the 20th century, the state’s usury laws had been enacted for almost every kind of loan. This meant that the lending of small amounts was practically banned virtually everywhere since lenders were unable to make a profit at the legally required rates of the charges.
The laws governing the Treasury set the maximum fees as proportional to the loan amount annually and resulted in a small dollar charge for short-term loans. In states with the 6% limit for loans, a lender who offers an amount of US$200 for a three-month term could charge just $3 total interest, and the monthly interest is just 0.5 percent. With such low rates, small-sum lenders would not be able to cover the cost of running their businesses.
However, working-class households needed access to credit, so the strict laws regarding usury did not reduce the need for this loan. Rate caps didn’t stop legitimate businesses from entering the market. The result was that borrowers had to deal with loan sharks who were willing to violate the law.
The charitable Russell Sage Foundation, which studied the issue in the early 1910s in the 1910s, called on states to exclude licensed small-sum lenders from generally enforced usury regulations. The foundation proposed an unofficial law, later referred to by the name of Uniform Small Loan Law, which allowed lenders to charge as much as 3 percent per month, or 36 percent annually, for cash loans of up to a few hundred dollars.
Presently, all 50 states remain in place to permit small-sum lenders to charge greater than 15% annually.
A return to the shark?
I think Sanders and Ocasio-Cortez have the right people to be worried about the high fees for credit cards and charges.
However, the loan Shark Prevention Act, as it is written, will not only bring us back to the year 1978 but would go all the way to the 19th century when low-income Americans who required credit for short periods were at risk of lenders. Conventional installment loans, as well as other providers of short-term, low-cost credit, will be wiped out through the bill.
This is due to the fact that the rate cap system, which works for large long-term loans, won’t work for shorter, smaller-term loans. Only a charity or government-subsidized lender, such as a postal bank, could offer short-term, small-dollar loans at a rate of 15% per year and make ends meet.
Millions of Americans depend on the availability of small-sized loans. Limiting the charge to 15 percent a year will not help to make loans more affordable. It’s going to eliminate the law-abiding business and leave more borrowers vulnerable to the whims of lenders.