Interest Rate Caps Shift Credit Access, the Fed Finds

What would happen if President Trump’s proposed 10% cap on credit card interest rates were enacted nationwide? The New York Fed recently examined the effects of interest rate caps imposed by several states—albeit at much higher levels—and found that credit wasn’t so much reduced as it was reallocated.

That said, the comparison isn’t entirely apples to apples. The analysis focused on caps as high as 36% in states like Illinois and South Dakota.

Even so, the findings align with what many industry analysts suspect would occur under a much lower cap. Lending to subprime borrowers fell sharply, with the number of credit accounts dropping by 20% compared with states that imposed no caps. In effect, the caps shifted credit away from lower-income borrowers toward consumers who were already more financially secure.

No Easing on the Budget

Subprime borrowers also saw their debt balances decline by 16.9% under a rate cap, but delinquency rates did not improve. In other words, the caps reduced access to credit without reducing the risks associated with it.

“Lowering credit card rates will not particularly ease household budgets,” said Brian Riley, Director of Credit at Javelin Strategy & Research. “A subprime account, with a score south of 720, has a wide range of obligations beyond just the credit card. Also in that budget are other loan products, such as auto financing, BNPL, and personal loans. These responsibilities often compete with expenses for daily living, rent or mortgage payments, and unexpected costs such as medical bills, auto repairs, and unstable employment.”

“A high-risk borrower is likely to default whether credit card APRs are 10% or 22%,” he said. “Factors such as strained employment and persistent inflation are wild cards that pressure household budgets, and those in riskier credit classifications are most vulnerable to unanticipated events.”

Pricing the Loan for Risk

Borrowers weren’t the only ones to see limited benefits. By constraining card issuers’ ability to price risk appropriately, interest rate caps can have adverse consequences for the overall lending pool.

“Credit scores, particularly those like FICO Scores, predict risk and help lenders navigate lending opportunities and risks,” said Riley. “Pricing the loan for risk is one of the most important components of lending, because it allows the lender to make granular assessments of the account’s ability and intent to pay. Risk-based pricing also ensures that the high risk of a weak credit account is not passed to a borrower classified as low risk.”

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Tags: Credit CardCredit Card Interest RatesFICOInterest RatesNew York Fed