Capping payday loan rates at 36% may not fully protect consumers—here's what researchers say will

Several states, including Illinois and Nebraska, recently put in place restrictions that cap interest rates at 36% on consumer loans, including payday loans. 

Advocates claim these restrictions protect consumers from getting in over their heads with these traditionally high-cost loans, but opponents maintain that these types of laws will reduce access to credit by forcing lenders out of business with unsustainable rates, leaving people nowhere to turn when they're short on cash.

New research published Monday seems to indicate that while these 36% rate caps may be well-intentioned, a different approach may actually have a greater impact on reducing the number of Americans who get caught in a so-called "debt trap" where they struggle to pay back the loan. 

Consumers may be best served by rules that require lenders deny borrowers any new loans for a 30-day period after they've taken out three consecutive payday loans, the report finds. About 90% of the  borrowers surveyed said they wanted extra motivation to avoid payday loan debt in the future, and this system would provide that without immediately limiting access to credit. 

"In our estimation, banning payday loans harms consumers on net, but regulations that allow payday lending, but limit repeat borrowing, can help consumers," says Hunt Allcott, one of the study's lead researchers and a visiting professor of law at Harvard University.

Payday loans can be easy to get, but hard to pay off. In the states that allow payday lending, borrowers can generally take out one of these loans by walking into a lender and providing just a valid ID, proof of income and a bank account. Unlike a mortgage or auto loan, there's typically no physical collateral needed and the borrowed amount is generally due back two weeks later. 

Yet the high interest rates, which clock in over 600% APR in some states, and short turnaround can make these loans expensive and difficult to pay off. Research conducted by the Consumer Financial Protection Bureau found that nearly 1 in 4 payday loans are reborrowed nine times or more. Plus, it takes borrowers roughly five months to pay off the loans and costs them an average of $520 in finance charges, The Pew Charitable Trusts reports. 

Implementing a 30-day "cooling off period" for payday loans allows consumers access to credit when they need it, but it also forces them to pay back the loan sooner (rather than continue reborrowing the loan), which is in line with what borrowers say they want for themselves in the long run, Allcott says. 

The cooling off period has to be at least a month because it has be long enough to actually force borrowers to go a pay cycle without getting a payday loan, Allcott says. 

"Most people, in the days after they've gotten paid, have a lot of money in their bank account. It's not until you get within a few days of your next paycheck that you're actually short of cash and need a loan to make ends meet," Allcott says. 

It's worth noting that Monday's research makes several key assumptions, including that rate caps on consumer loans, including the 36% model, will effectively act as a total ban on payday lending. 

Additionally, the research doesn't take into account the effect of moderate interest rate caps or rules that encourage people to gradually pay back loans, which have been implemented in Ohio and the now-rescinded 2017 rule from the Consumer Financial Protection Bureau. 

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