In the first of a series of posts reviewing studies that are particularly helpful in understanding the nature and role of Traditional Installment Loans, we examine the 2019 study How do Small-Dollar Nonbank Loans Work? conducted by Thomas W. Miller Jr., a senior affiliated scholar with the Mercatus Center at George Mason University, whose research for its Program on Financial Regulation, focuses on small-dollar loans.
This is an important study for the understanding of nonbank credit in general and installment loans in particular, in that it provides a detailed overview of the landscape for small-dollar loans and examines a number of products, including NILA-style Traditional Installment Loans offered by nonbank consumer finance companies.
The study is strong on history, pointing out that specially licensed lenders, making installment loans at set rates, were established via the Uniform Small Loan Law of 1916, specifically to give borrowers a safe and affordable alternative to loan sharks, who before that had operated with impunity.
Critically, it also reviews the case for 36 percent Annual Percentage Rate (APR) caps, noting that the net effect of a 36 percent APR cap is that loan sizes below a certain amount are unsustainable for lenders, leaving demand for those loans unfulfilled. In explaining this, the study illustrates the point NILA has made repeatedly, that APR is not the same as interest rate, and can be misleading, saying:
Through a series of rigorous studies…reformers determined that the costs and risks of small-dollar installment lending merited a monthly interest rate of 2.5 percent for amounts over $100 and 3.5 percent for amounts up to $100.25. These rates—[translate] to APRs of 30 and 42 percent…. The 36 percent rate cap prevalent today stems from this….
The study then explains the problem with 36 percent APR caps today:
One hundred years ago, consumer advocates, working with potential lenders with the capital to make loans, determined that a 36 percent interest rate was reasonable. Over time, however, while the revenue generated by loans of a particular size has remained constant, the costs of producing loans have increased. Costs of producing loans include employee salaries, employee benefits, rent and other operating expenses, regulatory compliance costs, and taxes.
It then examines the breakeven rates for lenders offering small-dollar loans, using the best available data, and finds that lenders facing a 36 percent interest rate cap cannot cover the costs of providing a $1,000 loan and “must increase the dollar size of the loans they make so that the increased revenue from the bigger loans exceeds the cost of making the loans”.
In its conclusion, the study calls on “the CFPB and other agencies” to push for the creation of another National Commission on Consumer Finance, “in the spirit of the bipartisan commission that Congress created by the Consumer Credit Protection Act of 1968”, saying:
There is much to learn about how the consumer finance markets have changed over the decades since the last commission did its work. An updated, careful, and detailed study about how and why consumers use credit products could help regulators and legislators better understand the markets they are charged with regulating.
In summary, this is an important study that provides plenty of food for thought for those interested in the business and regulation of small-dollar loans. In addition to the core content, the initial overview section provides a historical context for the current state of the industry, and, at the end, it provides a glossary of terms, useful for those seeking to master the subject, alongside a meticulously assembled list of Further Reading.
NILA commends How do Small-Dollar Nonbank Loans Work? to policymakers and all those interested in establishing a fair social, political and regulatory environment for small-dollar loans.
SOURCE: Mercatus Center