Prime Interest Rates for Subprime Borrowers?

• Publication year: 2010

Georgia State University Law Review

Volume 26 . „

Article 9

Issue 4 Summer 2010

5-31-2012

Prime Interest Rates for Subprime Borrowers?

Fred H. Miller

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Recommended Citation

Miller, Fred H. (2009) "Prime Interest Rates for Subprime Borrowers?," Georgia State University Law Review: Vol. 26: Iss. 4, Article 9. Available at: http://digitalarchive.gsu.edu/gsulr/vol26/iss4/9

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PRIME INTEREST RATES FOR SUBPRIME BORROWERS?

Fred H. Miller*

Past

In the United States the price of goods, services, and real estate has seldom been regulated by anything other than market forces, except in unusual circumstances where demand is high but supply is low, such as in war time. However, that has virtually never been true for the price of money. The price of money has been regulated since colonial times by legislative enactments.¹ This exception to the general rule of market regulation usually is premised on the belief that persons do not borrow until they need to, and a necessitous borrower has little or no bargaining power or knowledge to bargain.

For a considerable period of United States history, legislative limits on what could be charged for a loan ("usury laws") were quite low, such as 6% to 12%.³ That level worked well enough up to after World War I when consumer credit was in its infancy, but as the demand for such credit grew in the 1920s for the purchase of automobiles, appliances, and other expensive consumer items, these laws began to seriously pinch, particularly if the credit sought was small amount, short term, and the prospective borrower posed some risk of repayment due to possible job loss, sickness, divorce, or other factors beyond the borrower's control when at that time there was not much of a social safety net beyond friends and family.

Some might consider that rationing by these usury laws was a good thing, since people ought not to encumber future income for

* George L. Cross Research Professor Emeritus, Univ. of Okla.; Of Counsel, Phillips Murrah P.C., Oklahoma City, OK.

1. Of course, this ignores to some degree the deregulation of rate limitations since the 1980's.

2. For this reason, legislative limits on the price of money usually do not apply to credit extended to businesses. For a long while they also did not apply to credit extended by sellers because, of course, a buyer need not buy on time. That quaint idea has been questioned by retail installment sales laws that regulate the price of sales credit.

3. Barbara A. Curran, Trends in Consumer Credit Legislation 15 n.5(1965).

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immediate needs when the cost of doing so is high.⁴ This perspective, however, was not persuasive to a borrower who needed cash to pay the rent or the mortgage, to obtain needed medical services, to repair the family auto so one could get to work, or perhaps so the family could eat.⁵ These consumers turned to the illegal market for credit— where the price was not regulated and repayment risk was reduced by the prospect of severe collection procedures.

Enter small loan laws, designed to make the small loan business attractive to legitimate lenders and to protect prospective borrowers against the abusive and coercive practices of some lenders.⁶ The premise of these laws is that small loans, repayable in installments, cannot be made profitably at the rates permitted under usury statutes. Accordingly, these laws permitted lenders who were licensed and regulated under the laws to charge rates, subject to specified

4. See the remarks of Senator Durbin on the introduction of S. 500, Protecting Consumers from Unreasonable Credit Rates Act of 2009, S. 500, 111th Cong. § 2(1) (2009), "If a lender can't make money on 36 percent interest, then maybe the loan shouldn't be made."

5. curran, supra note 3, at 5.

6. Id. at 16.

7. Consider a small loan of $300 under these statutes repayable at the end of a year (for ease of computation) at a usury rate of 10%. The lender receives $30 to cover the cost of making and administering the loan, the cost of money to the lender, taxes, a reserve for bad debt, and profit. If instead $3000 were loaned on the same terms, the lender would receive $300. A dollar only stretches so far.

As William M. Clark, in his study entitled An Economic Analysis of the Oklahoma Installment Loan Industry wrote:

[C]onsider a small Installment Loan office with 750 active accounts and receivables of $250,000, which typically incurs fixed costs (including salary, rent, etc.) of approximately $166 per loan per year while variable costs (such as the cost of capital and bad debt expense) account for around thirty-five percent of loans outstanding. Given this model... [the total annual cost of a $100 loan would be 201%, and of a $500 loan, 68%]. ... [A] minimum APR of about eighty percent is needed to recover operating costs on an average small loan. Including... [taxes and a return on invested capital] . . . implies a breakeven APR of over one hundred percent. Considering this cost structure, Installment Loan APRs ranging from 70.38 percent (on a ten-month $800 loan) up to 240 percent (on a one month $10 loan) are economically necessary.... 60 Consumer Fin. L.Q. Rep. 487, 492-93 (Fall 2006) (on file with author). Payday loans present similar statistics, except involving smaller amounts and shorter terms, which drives the necessary APR even higher; the average in Colorado in 2007 was 318%, but could beashighas521%foral4 day loan of $300 at the maximum $60 finance charge. Press Release, Colo. Attorney Gen., Attorney General's Office Releases Annual Lending Data (Nov. 3, 2008), http://www.coloradoattomeygeneral.gov /press/news/2008/.

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ceilings,⁸ in excess of the maximum rates permitted under applicable usury statutes for small loans of $300 or less. It was thought that loan sharks, with exorbitant rates and unscrupulous collection methods, would be forced out of business because of this legislation.⁹

Other inroads on usury laws also developed once the ice was broken. For example, in 1910 Arthur Morris devised the Morris Plan, which involved a loan at usury rates and a "separate" transaction where the borrower deposited installments into a "savings account" with the lender. The account balance ultimately was used to pay off the loan at maturity.¹⁰ The deposits with the lender effectively reduced the amount the lender had outstanding on the loan, which was earning interest on the full amount lent and so the effective interest rate was almost doubled. Courts permitted this device, just as they permitted the common law time price doctrine; judges also recognized reality. There also were separate pawnbroker laws, which invariably allowed a greater rate than the usury rate. Without going into more detail, exceptions to the usury laws proliferated as the twentieth century progressed until the usury laws controlled very little of the price for credit, and perhaps justifiably so as a realistic matter.¹¹

However, there was a down side to this pattern. It existed in these numerous specialized exceptions to the usury law that were designed to help consumers in favor of a particular types of creditors. The exceptions generally were reflective of the type of credit extended by that class of creditor. Thus banks, thrifts, and large consumer finance companies specialized in larger, longer-term loans and required more

8. Under section 13 of the 1942 Uniform Act, 36% on the first $100 of a loan and 24% on any larger balance, computed as simple interest, and no other charges were allowed. Uniform Small Loan Law § 13 (Seventh...