When Rules Backfire: The Unintended Fallout of APR Caps on Subprime Borrowers

Current 22-Day Loan

• Loan Amount: $500
• Loan Term: 22 days
• Fee Charged: $100
• Total Repayment: $600 (Loan + Fee)
• APR: 331%

90-Day Loan at 36% APR

• Loan Amount: $500
• Loan Term: 90 days
• Fee Charged: $44.38
• Total Repayment: $544.38 (Loan + Fee)
• APR: 35.92

What Does This Mean?

• For Borrowers:
  • The longer-term Loan (90 days) costs less in fees ($44 vs. $100).
  • You’ll repay $544.38 over 90 days instead of $600 in 22 days, so it’s more affordable in the short term.
• For Lenders:
  • The fee income is much lower ($44 vs. $100).
  • Lenders must adjust loan offerings or find ways to cut costs to stay profitable.

This clearly shows how the 36% APR cap limits fees and spreads out repayment over a longer time, benefiting borrowers but reducing lender revenue per loan.

2. Shifts in Loan Product Offerings

• Shift Away from Payday Loans:
  • Traditional payday loans and cash advances with high fees and short terms become less viable under the 36% APR cap.
  • Lenders may pivot to offering installment loans or lines of credit, which can fit within the 36% APR framework.
• Bundled Services: Some lenders will add services like credit monitoring or financial literacy programs to offset revenue losses indirectly.

3. Operational and Financial Impacts on Lenders

• Revenue Decline: The cap reduces income per Loan, especially for subprime lenders relying on high short-term fees.
• Increased Compliance Costs: Lenders face higher compliance and reporting costs to ensure adherence to the APR cap.
• Consolidation in the Market: Smaller or niche lenders may exit the market, leaving larger or more innovative players to dominate.

4. Borrower Impacts

• Access to Credit: While the cap aims to reduce predatory lending, it has unintentionally reduced access to credit for high-risk borrowers, as lenders become less willing to take on risk under a capped profit model. [*Illinois Study: See Below.]
• Potential Rise in Loan Rejections: Borrowers with lower creditworthiness may be deemed unprofitable, increasing rejection rates.

5. Secondary Impacts

• Alternative Lending Growth: Borrowers may turn to unregulated or less-regulated lenders, including online or peer-to-peer platforms, potentially leading to predatory practices outside the cap.
• Increased Demand for Title Loans or Pawn Services: Borrowers unable to access traditional cash advances will seek alternatives like title loans, which often fall outside the cap in some states.

Lenders affected by a 36% APR cap can explore several alternatives to maintain profitability while adhering to the regulatory environment. Here are some key options:

1. Shift to Installment Loans

• What It Is: Instead of offering short-term loans, provide installment loans that are repaid over a longer period with lower monthly payments.
• Why It Works: The APR cap is easier to meet with longer repayment terms, and lenders can earn more overall interest.

2. Offer Larger Loan Amounts

• What It Is: Increase the minimum loan amount offered (e.g., from $500 to $1,000 or more).
• Why It Works: Spreading operational costs over a larger principal allows lenders to stay profitable despite capped fees.

3. Introduce Subscription-Based Lending

• What It Is: Charge customers a subscription or membership fee to access credit services rather than relying solely on interest or fees.
• Why It Works: This creates a steady revenue stream that doesn’t count toward APR calculations.

4. Focus on Secured Loans

• What It Is: Shift to loans backed by collateral (e.g., title loans and pawn loans).
• Why It Works: Secured loans are less risky, allowing lenders to offer lower interest rates while minimizing defaults.

5. Develop a Line of Credit

• What It Is: Provide an open-ended line of credit where borrowers only pay interest on the amount used.
• Why It Works: Lines of credit often have different APR structures and appeal to customers seeking flexibility.

6. Add Value-Added Services

• What It Is: Bundle loans with other services like financial counseling, credit repair, or budgeting tools.
• Why It Works: These can be offered for an additional fee or as part of a premium lending package.

7. Focus on Low-Risk Borrowers

• What It Is: Tighten credit standards to lend only to borrowers with better repayment histories.
• Why It Works: Lower default rates improve profitability, even with capped fees.
• The Bad: This policy eliminates the ability of millions of consumers in financial distress to access emergency funding.

8. Partner with Employers or Businesses

• What It Is: Offer salary-advance programs or employee-focused credit solutions through employer partnerships.
• Why It Works: Employers act as intermediaries, reducing risks for lenders and creating a captive borrower base.

9. Explore Alternative Revenue Models

• What It Is: Generate income from advertising, affiliate partnerships, or commissions on third-party financial products.
• Why It Works: Diversifies revenue streams beyond lending fees.

10. Use Advanced Risk-Based Pricing

• What It Is: Implement dynamic pricing models based on individual borrower risk, adhering to the APR cap while maximizing revenue for lower-risk borrowers.
• Why It Works: Ensures compliance while optimizing earnings.

11. Leverage Technology for Efficiency

• What It Is: Use automation and AI to streamline loan underwriting, servicing, and collections processes.
• Why It Works: Reducing operational costs allows lenders to remain competitive despite lower fee income.

12. Move to States/Tribal Lending Models with No APR Caps

• What It Is: Relocate or expand operations to jurisdictions without restrictive APR caps.
• Why It Works: This can provide regulatory relief, although it may require significant upfront investment.

Each of these strategies comes with its own set of challenges and regulatory considerations. The right approach will depend on your customer base, business model, and geographic location. Future Considerations

• Legislative Adjustments: States or federal agencies may tweak regulations to address unintended consequences, such as access to credit gaps.
• Lender Innovation: Expect increased creative lending models, such as subscription-based lending, BNPL, revenue-based financing, or embedded credit in other services.
• Consumer Education: Educating consumers on APR impacts, loan structuring, and alternative credit options will become increasingly vital.