Lending laws are changing — and borrowers could pay the price

State and federal authorities are struggling with usury and interest rate cap limitations as new technologies change the way that financial services are delivered and allow some lenders to circumvent them. Many states are opting for traditional solutions that may actually be worse than the abuses they are trying to prevent.

On Wednesday of this week, Colorado enacted legislation opting out of a federal law that allows out-of-state banks to avoid adhering to their usury laws. In contrast, the actions by federal authorities to prevent a national patchwork of state interest rate caps from constraining commerce and broader financial markets by undercutting the “valid when made rule” were upheld by a California court. Other states, including Maine, have redefined how usury laws apply to fintech companies, which buy loans from banks that may not have been subject to their usury law when the loan was made.

This battle has been percolating for 50 years, but technology has brought it to a head once again.

Usury laws were very important when people’s access to credit was limited by how far they could ride on horseback to find it. But the world has changed as borders have disappeared in cyberspace. States are naturally reluctant to give up control over lenders even in the face of overwhelming data indicating that well-intentioned interest rate caps can lead to less credit availability, higher rates and economic dislocations for those who need the credit the most.

When usury rates reflect political grandstanding rather than actual market conditions, lenders may choose not to lend to borrowers with weak credit histories in those states if they can’t do it profitably. In 1964, after an investigation into loan sharking by the New York State Investigations Commission, then-Sen.-elect Robert F. Kennedy identified New York’s usury laws as a key driver of loan sharks’ success in the state and recommended modifying them so that more people with credit problems could borrow from legitimate sources. 

Consider Pete, whose credit history is not the best. He takes out a 14-day payday loan of $500 at 10 percent simple interest to cover some emergency medical expenses. The $50 administrative processing fee that is also charged produces an annual percentage rate (APR) of 282 percent. That number — not the 10 percent interest — is what must be disclosed under federal and many state laws. It is a distinction that most ignore when considering the issues. Pete did not blink an eye at the 10 percent rate, given his credit history, or the $50 processing fee, but a 282 percent APR gets everyone’s attention. This example demonstrates the complexity of the issue: If the small-dollar lender can’t charge the 282 percent APR for those 14 days, it may choose not to lend, leaving Pete in the lurch.

Data about the unintended consequences of usury laws is creating a clearer picture of those consequences. Recent research assessing the impact of the 2021 Illinois law on small-dollar loans found that the interest rate caps made credit less available and more expensive by decreasing the number of unsecured short-term loans to subprime borrowers by 44 percent and increasing the average loan size to subprime borrowers by 40 percent. That was likely helped by the fact that the law shortsightedly applied its restrictions to anyone who purchased the loan in the secondary market, where most loans end up, effectively making those loans less valuable and less saleable. The law also changed the permissible interest rate that could be charged from the simple interest rate to the APR. 

A 1982 Federal Reserve Bank of Chicago paper noted that “[u]sury laws can succeed in holding interest rates below their market levels only at the expense of reducing the supply of credit to borrowers.” In 2013, a study by the University of Bristol found that interest rate caps impact credit availability and reduce access for low-income consumers. Another paper in 2021 noted a direct link between the capping of interest rates and a 20 percent reduction in credit availability.

Egregious interest rates hurt the most vulnerable, but interest rate ceilings keyed to the APR on small consumer credit loans can have unintended consequences. Both the states and the federal government have a legitimate oversight role to play in lending markets. But when the 90 percent of consumers who are internet-connected make up lending markets, they naturally have greater choices for financial products and services, leveling the playing field.

As attractive as interest rate caps may seem, they have a checkered history and can be a painful medicine for those that need access to credit the most. Lenders simply may choose not to lend to high-risk customers who need small-dollar loans if they can’t do so safely and at a rate that is commensurate with the credit risk that they are taking. Politics should take a back seat to analytics when it comes to creating new usury laws — otherwise, we shouldn’t be surprised when consumers wonder where all the credit has gone.

Thomas P. Vartanian is executive director of the Financial Technology & Cybersecurity Center. A former bank regulator, he has acted as an expert witness in state usury cases arising from the implementation of new financial technologies. He is the author of “200 Years of American Panics” and “The Unhackable Internet.”