Which is more expensive for low-credit consumers – the daily cost of a short-term loan or bank overdraft fees? The answer might surprise you.
Short-term loans continue to receive a bad rap in American political discourse and are routinely viewed as predatory by lawmakers who believe they unfairly target low-income Americans. These lawmakers, both federal and state, argue that short-term lenders take advantage of vulnerable Americans by offering high-interest loans they cannot afford to repay. Therefore, they conclude that strong consumer protections are needed to limit these unsavory business practices. Strangely, these same legislators often have little to say about bank overdraft fees and a much greater burden on consumers.
Over the past decade, 19 states have passed laws and regulations imposing interest rate caps on small loans. Pressure for action at the federal level has also increased. Last year, several senators proposed legislation establishing a 36% annual rate cap on short-term loans, effectively banning all loans with an interest rate above 36%.
Such a proposal, if passed, would prove devastating to short-term lenders who rely on the ability to adjust interest rates to insulate them from high-risk consumers. Research suggests that high interest rates are often necessary to recoup the cost of delinquent loans and generate even the smallest profits. The loss of this flexibility has repeatedly led companies to exit the market in states like Illinois, where a 36% price cap has been established.
A national cap on interest rates would be even more detrimental to consumers. Indeed, the 12 million Americans, or 5.5% of the population, who use short-term loans tend to be unbanked or underbanked. These Americans do not have access to credit at traditional financial institutions or have limited access to borrowing from other lenders. In both cases, these Americans rely on other forms of credit available to them only through short-term lenders.
Therefore, an arbitrary 36% annual percentage rate cap would have a negative effect on these Americans.
Unlike the strict regulations imposed on short-term lenders, many large banks face few restrictions on the practice of generating profits from overdraft fees. Overdraft fees, which the bank charges customers who withdraw more money from their accounts than they have, are an important source of revenue for banks. According to the Consumer Financial Protection Bureau, overdraft fees and insufficient fee income account for “nearly two-thirds of reported fee income.” In 2021, consumers paid over $8 billion in overdraft fees.
Unfortunately, according to the Federal Reserve, these revenues are frequently collected from Americans who are more likely to be “low-income adults, less-educated adults, and black and Hispanic adults.” In fact, a CFPB study found that “8% of customers bear nearly 75% of all overdraft fees,” meaning that Americans who can least afford to make such payments are responsible for a disproportionate share of overdrafts.
A brief comparison between a typical short-term loan and standard overdraft fees illustrates the absurdity of focusing on strict rate caps for payday lenders while banks continue to charge high overdraft fees.
For example, an annual percentage rate cap of 36% applied to a two-week loan on $200 equates to a consumption charge of only 0.6% per day for the loan. In contrast, a number of major banks charge an overdraft fee of $36, which translates to an effective one-day rate of 18%. To summarize, we see a short term loan with an annual percentage rate of 36% and bank overdraft fees with an annual percentage rate of 915%.
This example demonstrates the huge disparity in accumulated profits between a typical short-term loan and a standard overdraft fee. Yet lawmakers seem determined to apply disproportionate scrutiny to payday lenders and deny high-risk consumers access to short-term credit.
Indeed, according to a 2016 report by polling firm Tarrance Group, 96% of borrowers said “the personal loans they took out were helpful to them personally.” Additionally, a 2020 Morning Consult survey found that a strong majority of Americans think “the amount lenders should be able to charge for a $100 loan over two weeks” should exceed the 36% cap proposed by the Congress.
The reality is that payday lenders are providing unbanked and underbanked Americans with a valuable service, and lawmakers are threatening to take it away. Americans who would otherwise not be eligible to receive a line of credit, many of whom are low-income and of color, can do so with a small dollar loan. That small loan can be all that keeps a family from paying next month’s rent or being evicted.
Lawmakers should resist the urge to impose caps on payday loans, which will only punish the people the law in question was designed to help. Such a regressive law would almost certainly drive consumers to seek out alternative, much riskier forms of credit, such as those available from loan sharks and shady pawnbrokers.
Instead, lawmakers should focus on the big banks that continue to enrich themselves at the expense of their poorest customers. It is overdraft fees, not payday loans, that penalize low-income Americans for not having enough money in their bank accounts. And it’s overdraft fees that constantly keep people away from banking.
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