Wednesday, 23 September 2009

Cap the Total Charge for Credit not APR's

Recent discussions over interest rate caps have included concerns that DWP Growth Funds are being used by credit unions and community development finance institutions ('CDFIs') to lend out at APR's of between 30% and 40%. Because these lender's aren't driven by profit motives, it has led some to argue that interest rate caps would not be a practical means of delivering fairer prices to low income borrowers and that they would drive all types of lenders out of business.

In fact there is no reason why price ceilings would not be an effective means of ensuring people aren't ripped off in uncompetitive credit markets including home credit or payday lending. Uncompetitive markets allow lenders to mark up prices over and above where they would be under normal market conditions. They therefore make excess profits. Caps can be used to reduce prices to the level where normal profits would be made - but should not be used to eliminate point profit altogether.

The question therefore is where to put the cap, not whether it could work in principle. Capping the price of credit is more complicated than in other markets simply because the APR measurement of price is subject to vagaries. It is skewed against short term lending. The shorter the term of the loan, the higher the APR. As a result, a cap on the APR% could result in lenders simply lengthening the term of their loans in order to bring down the headline % figure.

So let's focus on a different measurement of price - the total charge for credit. Provident Financial, the UK's largest door to door lender with over 50% of the market, charge about £65 for every £100 borrowed. That’s a Total Charge for Credit (TCC) of 65%. Payday lenders typically charge between 15% and 33% total charge for credit on the first month, but this figure doubles each time the loan is rolled over. As for credit unions and CDFI's, well APR’s of 30% to 40% may sound grim, but the total charge for credit on these loans lies between just 8% and 10%.

We need to forget APR’s in this debate and support a cap on the Total Charge for Credit at somewhere around 20%. That would deliver real savings to low income borrowers and wouldn't put non exploitative lenders out of business, but it would ensure that Provident, for example, were no longer able to benefit from a lack of effective price competition and it would limit payday lender irresponsibility.

Of course, there are alternatives to capping - for example by encouraging greater competition in the first place. But since the financial crisis has hit this is likely to take anything between four and ten years to happen. And it's already been 6 years since we first highlighted the lack of effective price competition in the door to door lending market, during which time by the Competition Commission's calculations around £0.5 billion has been taken out of the poorest communities in excess profit.

So let’s not wait another decade to deliver fair prices. And let's not divide those that are on the side of low income borrowers – we know where the real problems lie. A united campaign for a cap now could make all the difference!

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