New study finds state laws that cap pay day loan interest rates hurt low income workers

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In Illinois, a coalition of social justice advocacy groups cited triple-digit APRs in campaigning for a bill that capped interest rates on small loans at 36 percent per year. When the so-called Predatory Loan Prevention Act became law in March 2021, the groups cheered it as “a significant milestone for economic equity in Illinois.”

A new study co-authored by a top economist at the Federal Reserve, however, finds that the law’s effects have been anything but equitable. Released through the Social Science Research Network, a prominent repository for academic papers in economics and social sciences, the paper finds that lower-income and disadvantaged borrowers have taken a massive hit due to the law. “Their overall financial well-being had declined,” the study reports. The study was conducted by Gregory Elliehausen, principal economist in the Consumer Finance Section of the Federal Reserve; Thomas Miller, professor of finance and Jack R. Lee Chair of Financial Institutions at Mississippi State University; and J. Brandon Bolen, Assistant Professor of Economics at Mississippi College.

These scholars find in their paper that the Illinois law decreased the number of short-term loans unsecured by collateral to at-risk borrowers by 40 percent. Utilizing survey data from Illinois borrowers whose lenders had stopped making loans due to the law, the scholars find that 49 percent of borrowers with incomes below $50,000 reported that their financial well-being had decreased, and only 11 percent of all borrowers said that it had increased. 79 percent of borrowers said they wished they had the option to return to their previous lender.

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The scholars conclude in their study that “the Illinois interest-rate cap of 36 percent significantly decreased the availability of small-dollar credit … and worsened the financial well-being of many consumers.”

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Under the Truth in Lending Act of 1968, providers of just about every loan and cash advance — even ones with a duration as short as two weeks — must disclose the interest rate as if the consumer were paying interest for an entire year. This is called the “annual percentage rate,” or APR as abbreviated. As my colleague Matthew Adams and I have written in a recent paper for the Competitive Enterprise Institute, this so-called annual percentage rate leads many cash-strapped consumers to misunderstand available options. Worse, by distorting the policy debate, the APR leads politicians at the federal and state level to propose banning these options.

To illustrate the absurdity of applying the APR to short-term lending, let’s look at a basic loan with a duration of two weeks. (These types of loans have become known as “payday loans” due to their length matching those of many employees’ pay periods.) As Adams and I explain in the CEI paper: “If a borrower takes out a $200 loan with a $30 finance charge for two weeks, the interest rate totals 15 percent. Yet, when that figure is annualized by multiplying it by the 26 two-week periods in a year, the APR becomes 390 percent, even though nothing about the loan’s features has changed.”

Applying the APR to short-term loans, the great economist Thomas Sowell has pointed out, is as ridiculous as multiplying the rate of a $100-per-night hotel room by the number of days in a year. “Using this kind of reasoning—or lack of reasoning—you could … say a hotel room rents for $36,000 a year,” Sowell writes, “[but] few people stay in a hotel room all year.”


Yet the specter of loans with a 300 to 400 percent interest rate – even though it is far in excess of what most borrowers pay – is wielded as justification for interest rate caps in several states.

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