We study the effects of interest rate ceilings on the market for automobile loans. We find that loan contracting and the organization of the loan market adjust to facilitate loans to risky borrowers. When usury restrictions bind, automobile dealers finance a greater share of their customers’ purchases, which allows them to price credit risk through the mark-up on the product sale rather than the loan interest rate. Despite having little effect on who receives credit, usury limits therefore have a substantial effect on who provides credit and on the terms of credit granted. Usury limits may harm defaulting borrowers, who face greater liabilities in default than they would if loan contracts were unconstrained.This is the abstract of a new working paper, Loan Contracting in the Presence of Usury Limits: Evidence from Automobile Lending (Consumer Financial Protection Bureau Office of Research Working Paper No. 2017-02) by Brian Melzer and Aaron Schroeder.
Melzer and Schroeder explain,
Usury restrictions are often motivated by the argument that lenders, if unchecked, will exercise market power and raise interest rates on risky borrowers beyond the level required to compensate for credit losses, origination costs, and required capital returns. Supporters of usury limits thus argue that lenders will respond to interest rate caps by extending credit at lower prices. Opponents counter that price ceilings will cause credit rationing, which reduces access to credit and harms precisely the risky borrowers that supporters of usury limits intend to help. We propose and investigate an alternative view that applies to the large market for certain subprime automobile loans: vehicle sellers can creatively contract around binding usury limits by financing their customers’ purchases and pricing default risk through the mark-up on the vehicle sale rather than through the interest rate.
The strategy of automobile dealers is simple. Vehicle loans are structured as installment contracts that require constant monthly payments for a fixed maturity (typically 3-6 years) and allow the lender to repossess the vehicle if the borrower defaults. Holding fixed the collateral, loan maturity, and principal amount, a lender is typically constrained to adjust the price of credit by changing the interest rate specified in the contract. For a lender that also serves as the vehicle seller, however, there is an additional degree of freedom—marking up the sales price of the vehicle. When the usury limit binds, the integrated dealer-lender can subsidize a negative net present value loan with a higher-margin sale. Within the loan contract, this change amounts to increasing the stated loan amount (along with the sales price) rather than the interest rate, thereby achieving the desired monthly loan payment while still complying with usury law. To give an example, a $9,000 loan at 30% interest has the same required monthly payment as a $10,650 loan at 20% interest over a four-year, fully amortizing term.
While dealers’ contracting flexibility allows them to approximate an unconstrained loan, it does not completely eliminate the friction introduced by the usury limit. First, the constrained and unconstrained contracts are not identical. When a dealer raises the stated loan amount instead of the interest rate, the borrower’s loan balance starts higher and remains higher until the end of the contract. Borrowers who prepay or default thus owe more to the lender when they terminate the contract. Second, risky borrowers may pay higher prices for credit, as their purchases depend upon financing from automobile sellers rather than a broader, and potentially more competitive, universe of third-party lenders. In an equilibrium with usury limits and dealer financing, therefore, few borrowers are completely excluded from the market, but dealers provide captive financing for a larger share of purchases and borrowers that receive dealer financing face different loan terms—lower interest rates, larger loan-to-value ratios, and possibly higher loan payments—than they would in the absence of usury limits (pp. 2-3).