I have written before about Annual Percentage Rate (APR) and how it is determined. See here.
The Federal Reserve Board defines APR as the cost of credit over time. The reality is that APR is only meaningful as a measurement tool for comparison shopping for substantially similar financial products. That is, it is meaningful only when comparing similar products—for example, one mortgage loan to another mortgage loan. Since APR is a function of the cost of credit over time, it loses its usefulness when the financial products being compared are not comparable as to the length of the term (months or years) or the amount financed (the dollar amount of the transaction).
And, certainly, APR is not an indicator of the affordability or the fairness of a financial product. A small dollar loan at 72% APR can be exceedingly fair, while an 18% APR loan for a great amount of money may be unconscionable. This is the fact that seems to get lost on the consumer advocate community in the 36% rate cap debate.
Studies have shown that consumer finance companies cannot cover their costs of doing business on loans under $2600 at a rate of 36% or less; and if credit insurance and gap waiver are included in APR, a loan must be $4000 or more to be profitably made. What this means is that if a 36% rate cap is imposed, lenders will have to limit their loans to higher dollar amounts, thereby declining to make loans of lower amounts that consumers may be seeking; or require consumers to borrow more than they may have intended to borrow—which in itself drives up the cost of borrowing.
The fact is that APR is a poor metric without more information and consideration. And, a 36% rate cap without considering the size and term of a loan is really bad public policy.
No doubt, there are troubling loan products being offered, including short term, single payment payday, and title loans. However, it is not the high APR even on those loans that is the problem; rather, it is the structure of these loans without an effective “off ramp” that makes them so insidious.
Traditional installment loans made only to customers with the ability to repay—with fixed rates, fully amortizing, and repayable in equal payments—are not the problem.
Please note: This is the eighty-fifth blog in a series of Back to Basics blogs, in which relevant and resourceful information can be easily accessed by clicking here.