The 2021 Liberal election platform – and the Prime Minister’s subsequent mandate letter to Finance Minister Chrystia Freeland – included a promise to “crack down on predatory lenders by lowering the criminal interest rate”.
Presumably, any new legislation aimed at fulfilling this commitment would primarily target “alternative lenders”: finance companies that typically offer payday, title or installment loan products. These loans primarily cater to those with low credit scores, few collateral, and short-term cash flow needs.
Payday loans are short term. Lenders charge a fee of around $15 to $17 per $100 borrowed over a two-week period until the borrower’s next paycheck. These fees may seem trivial. But calculated as an annual percentage rate (APR) of interest, these rates are very high (around 400%). Payday rates are exempt from the 60% statutory interest rate cap due to their low dollar value and short term duration.
With installment and title loans, a borrower can take out a loan between a a few hundred to $20,000 or more. Both types of loans have terms ranging from a a few months to five years. While the interest rates on these loans (about 20 to 50 percent) are lower than for personal loans, they remain very high. Given the higher borrowed capital and longer payment terms, cash payments can be very expensive.
It’s easy to see why the government’s commitment to lowering the maximum allowable interest rate is superficially attractive. After all, if unscrupulous Canadian companies are defrauding Canadian consumers, shouldn’t we welcome new laws that prevent them from overtaxing us? Some politicians and consumer advocates are calling for the maximum loan rate of 60% to be lowered Between 20 at 30 percent.
The fact is, however, even with the very high rates charged, alternative lenders fill a market need. There are few other borrowing options for people with low or no credit.
Traditional banks and credit unions primarily limit personal loans and lines of credit to borrowers with acceptable collateral and credit ratings. In one federal government study Among payday borrowers, only one in three surveyed said they had access to a credit card and only 10% had a line of credit available. Payday loan customers also point to better customer service and the ease, speed and convenience of obtaining such a loan.
Related, but more disturbing reports indicate that some payday loan customers are not comfortable in established financial institutions. In other words, they think their business is unwanted and feel discriminated against. Several credit unions have introduced loan products tailored to unsecured and low-credit customers, but the supply of credit is far from sufficient to replace the alternative lending industry.
Alternative lenders charge high rates because the loans they provide are risky. Fault rates are higher than those of traditional financial institutions. Physical storefronts add to a high fixed costs business model. Lowering the interest rate cap as much as a few politicians and low-income advocates have called for would make lending to people with low credit ratings unprofitable.
The same government study mentioned above also indicated that common reasons for needing a loan were day-to-day expenses such as car repairs, rent, or to avoid late payment charges on a bill. Less than one in 10 said it was to “buy something special”.
According to these responses, access to short-term funds is essential to respondents’ financial well-being. They may need a car to work. Unpaid bills could lead to late payment fees and even lower credit scores, while missing a rent payment could lead to eviction. Studies also report that “credit enhancement loans”, a type of installment loan product, can help improve the credit scores of people with poor credit. Restricting or eliminating alternative lenders will reduce access to credit and increase the financial consequences for those who can no longer borrow.
That doesn’t mean the government can’t take steps to regulate credit markets to stamp out abuses. Several practical steps can be taken. The first is the type of information lenders receive when obtaining high-cost, short-term loans. Provide clear, easy-to-read loan information in a way that allows borrowers to think through and compare loan costs, tracks fewer loans used. Second, since people with more financial knowledge use less loans, improving financial literacy is also important. Finally, limiting the number of high-cost loans over a period reduces the risk of a borrower falling into a debt trap. If we can significantly reduce the use of high-cost loans without restricting access to credit, we can avoid the unintended negative consequences that frequently occur when we use market savagery tools.
It is understandable and appropriate that governments are concerned and seek to protect financially vulnerable Canadians. But lowering the maximum legal interest rate could backfire badly and harm those they are trying to help.