APR rules on short-term loans mislead consumers


As public health takes a turn and the travel industry begins to recover, imagine if the federal government imposed a crazy rule on hotel price disclosure. Regardless of the length of a guest’s stay, hotels should list prices as if guests were staying for a year. So the $ 100 per night room stay should be listed on websites and in hotel advertisements as $ 36,000, as that is the total when the nightly rate is multiplied by the 360. days of the 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 1968 Truth in Lending Act, providers of almost all loans and cash advances – regardless of the term – must disclose the interest rate as if the consumer was 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 yet, by distorting the political debate, the RPA leads politicians at federal and state level to propose banning these options.

Take the very vilified payday loans. If repaid during their two week term, the interest rate typically hovers around 15-20%. But because the law requires lenders to list the annual rate, even if borrowers pay off a loan well before a year, the official interest rates for them suddenly appear between 390 and 520%. This artificial interest rate leads politicians, knowingly or not, to further distort the debate by opposing “usurious” loans.

The data on short-term loans clearly shows that the APR for short-term loans does not match the experience of most consumers. While many payday borrowers take more than two weeks to pay off 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 in six weeks, generating real interest rates of 45-60% at the high end. These rates may still seem too high to some, but they are a far cry from the triple-digit rates that generate alarming stories.

In addition, the myth of the 400% blunts the argument that small loans can often be the least bad option for consumers. Often the alternatives to payday loans are not loans at lower rates, but rather bad checks and late payments, which come with their own costs such as a deterioration in a credit rating.

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 real experience and needs of consumers. Lawmakers should control disclosure, but otherwise take a hands-off approach. We should all want to encourage lenders to be competitive and innovate to provide consumers with services that meet their needs and foster financial inclusion, regardless of wealth status.

Congress must modernize the APR disclosure mandate of the Federal Truth in Lending Act 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 undermine the resilience of American entrepreneurs and consumers in these difficult times.


John Berlau is Principal Investigator at the Competitive Enterprise Institute.


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