New York Fed Confirms Rate Caps are a Bad Idea

A recent study conducted by the Federal Reserve Board of New York focused on the effects of usury limits on high-risk borrowers, and the findings should give pause to lawmakers pushing for rate caps on both the state and federal level.

Rate caps are ceilings on the maximum interest rate lenders can charge.The study confirms orthodox economic views on rate caps by demonstrating that they lower the amount of available credit for riskier borrowers.

Interest can be conceptualized as the price of borrowing money over a certain time horizon, compensating the lender for parting with money that they could have employed in alternative ways. When rate caps set a limit on how high interest can be charged, the result is that all borrowers whose risk profile demands an interest rate above that limit are shut out from borrowing.

Lenders charge more for riskier borrowers to offset the default risk. So when rate caps prevent lenders from pricing in risk, they no longer have an incentive to lend to risky borrowers. 

The New York Fed’s study found that the riskiest borrowers saw their loan balances decline after rate caps took effect across three states (Illinois, South Dakota, and North Dakota) between 2016 and 2022, but their delinquencies did not improve. In other words, they were worse off because they had less access to credit, and cutting credit access did not make repayments easier. This means the underlying risk profile of the borrowers did not improve as a result of being turned away from additional credit access.

Rate caps do not improve creditworthiness for risky borrowers; they just make lenders unwilling to serve them. The lower balances observed in the study is not due to improved financial health, but rather a government imposed price ceiling. that ignores the real cost of lending to higher-risk customers. For households relying on small-dollar loans to cover emergency expenses, that missing credit doesn’t vanish as a need, it just becomes harder to source through legitimate channels.

The New York Fed’s study is not the only type that has been published on this topic. Academic economists widely agree that rate caps constrict credit, reduce consumer welfare, and often hurt low-income borrowers, and the neediest households the most.  

Lawmakers should allow markets to set interest rates to calibrate the true cost of borrowing and stay out of people’s personal financial decisions. While policymakers think they are good-intentioned in their efforts to alleviate issues involving debt and consumer protection, they are merely replacing those problems with others as people will be more inclined to seek informal sources of credit or suffer missed payments and the inability to meet their basic needs. To quote Hayek, “the road to political hell is paved with good intentions”.