Myth: Capping the annual percentage rate (APR) on small-dollar loans protects consumers.
In fact, well-structured small-dollar loans, such as traditional installment loans (TILs), can help individuals survive a financial crisis. A study conducted by George Mason University demonstrated that limiting access to small-dollar loans greatly reduced consumers’ likelihood of surviving times of economic uncertainty. Traditional installment loans help address the immediate needs of consumers, providing much-needed time and support to weather a financial storm or to identify longer-term solutions to financial challenges.
While interest rate caps clearly shut down some of the least safe forms of consumer credit (such as title loans), they also shut down one of the safest and most important forms of small-dollar consumer credit—traditional installment loans. At the same time, such caps leave untouched other unsafe products (such as mortgage-backed revolving credit and unregulated, offshore, and Internet loans). When TILs are not available, people often turn to these less safe and undisciplined forms of credit.
What determines whether a loan is safe is the way it is structured. Using interest rate caps as a way to prevent unsafe loans makes about as much sense as banning all red cars. In the process, some unsafe cars will be taken off the road, but so will some of the safest, while leaving many unsafe cars on the highway.
TILs are structured to be both safe and responsible.
Myth: Traditional consumer installment loans are “high-cost” loans.
For example, consider the difference between a $500 loan with a 36% APR versus a $500 loan with a 69% APR. When paid over a seven-month period under a traditional installment monthly payment plan, the 36% APR loan carries a monthly payment of $80, compared to a monthly payment of $89 for the 69% APR loan. The difference is actually only 30 cents per day.
Myth: The U.S. military restricts the use of traditional installment loans for military service members.
In fact, the Department of Defense specifically exempted traditional installment loans from the rate cap limits in the 2007 John Warner Defense Authorization Act, which in its final rule notes the need to “isolate detrimental credit products without impeding the availability of favorable installment loans.”
Myth: If mortgage lenders can make loans at 5% to 8%, small-dollar lenders should be able to make loans at interest rates of less than 36%.
Interest rates on TILs are agreed to by the borrower and lender at levels that the lender determines will cover both the lender’s fixed costs of operating his business and the risk of non-payment by the borrower. Traditional installment lenders properly underwrite their loans by evaluating both the borrower’s creditworthiness (checking the borrower’s credit report and other credit references) and the borrower’s ability to pay (checking the borrower’s sources, stability, and reliability of income).
For this reason, traditional installment lenders are able to offer credit to qualifying borrowers at market rates that are far lower than the rates offered by lenders who do not conduct similar underwriting, such as payday lenders.
Myth: Traditional installment loans are just another name for payday loans, or “payday lite.”
In contrast, payday loans are short-term, single-payment loans that are typically due in either two weeks or one month, based on the borrower’s payday cycle. Payday loans also come with no payment plans, except for the requirement to pay the entire balance, known as a balloon payment, at maturity. It is entirely inaccurate to lump traditional installment loans together with payday loans of any form.
Myth: Small-dollar loans are predatory and given to anyone who walks in off the street.
TIL lenders work with successful applicants to structure the loan in a way that builds in consumer protections and gives the borrower a clear path out of debt. The amount borrowed is paid off over the term of the loan with fixed, equal monthly installments of principal and interest, with no balloon payments. In this sense, traditional installment loans are like a standard mortgage or car loan from a credit union or bank. TILs offer a safe and affordable option for consumers.