As public health takes a turn and the travel industry begins to recover, imagine if the feds imposed a crazy rule on disclosing hotel prices. Regardless of the length of a guest’s stay, hotels should quote prices as if guests were staying for a year. So the stay for a room at $100 a night should be listed on hotel websites and advertising at $36,000 because that’s the total when the rate per night is multiplied by the 360 days of a year .
Ridiculous, you say. But as economist Thomas Sowell points out, a similar rule governs the pricing of short-term loans, causing confusion and harm to many consumers trying to rebuild their credit and their lives in this pandemic era.
Under the Truth in Lending Act of 1968, providers of nearly all loans and cash advances — regardless of term — must disclose the interest rate as if the consumer were paying interest for an entire year. As my colleagues Matthew Adams and I write in our new paper for the Competitive Enterprise Institute, this so-called annual percentage rate leads many cash-strapped consumers to misunderstand the options available. Worse, by distorting the political debate, the RPA leads politicians at the federal and state level to propose banning these options.
Take the much maligned payday loans. If they are repaid during their two-week term, the interest rate is usually around 15-20%. But because the law requires lenders to list the annual rate, even if borrowers repay a loan well before a year, the official interest rates for these suddenly appear between 390 and 520%. This artificial interest rate leads politicians, wittingly or unknowingly, to distort the debate further by railing against “sharking” loans.
The data on short-term loans clearly shows that the APR of short-term loans does not match the experience of most consumers. While many payday borrowers take longer than two weeks to repay what they owe, almost no one has been shown to take a year. Data, including from the Consumer Financial Protection Bureau, strongly suggests that most payday borrowers pay off what they owe within six weeks, earning real interest rates of 45-60% at most. These rates may still seem too high to some, but they are nowhere near the triple-digit rates that generate scare stories.
Additionally, the 400% myth blunts the discussion of how small loans can often be the least bad option for consumers. Often the alternatives to payday loans aren’t loans at lower rates, but rather bounced checks and late payments, which come with their own costs, such as damage to a credit score.
At the federal and state level, politicians and bureaucrats should set aside the APR as a focal point when discussing small loans and learn more about the true experience and needs of consumers. Lawmakers should monitor disclosure, but otherwise take a hands-off approach. We should all want to encourage lenders to compete and innovate to provide consumers with services that meet their needs and promote financial inclusion, regardless of their wealth status.
Congress must modernize the APR disclosure mandate of the federal Truth in Lending Act of 1968 to reflect the true cost of credit for short-term loans and advances. We must not let the federal government’s outdated financial measures hamper the resilience of American entrepreneurs and consumers in these trying times.
John Berlau is a senior researcher at the Competitive Enterprise Institute.