Interest Rate Caps Should be a Policy of Last Resort

Earlier this year, Ottawa reduced the highest interest rate lenders can legally charge from 48 percent to 35 percent. To most of us, both rates seem extortionately high, but they are part of many Canadians’ reality. Unfortunately, lowering the cap will make it harder for these Canadians to get the credit they need. And it will worsen their already precarious financial situation.

Last year I argued that a price cap – which is what the law imposes – should be a policy choice of last resort. The government clearly didn’t listen. But with the economy struggling and uncertainty rising, we need to re-evaluate past policies and make sure we’re not keeping credit out of the hands of those who need it most.

The federal government argues that predatory lending is a significant problem for the most vulnerable Canadians. To justify lowering the maximum legal interest rate to 35 percent it performed a cost-benefit analysis.

On the benefit side the lower rate produces fewer predatory payday loans, fewer borrowers making use of them and lower interest rates on the loans that are made. The government estimates $225.9 million in (present value) savings to consumers over the next decade. On the cost side: Payday lenders’ (present value) profits fall by an estimated $207.6 million. Net benefit? $2.4 million a year (annualized value).

That’s not actually very much, but the lower rate does generate a net monetary gain.

The problem comes in the details of the calculation.

The savings include a reduction in the number of borrowers, which the government puts at “close to 45,000 Canadians.” It argues that these Canadians will either find other sources of credit or delay discretionary spending. But there’s no analysis backing this up. If these borrowers did have access to lower-cost debt, they presumably would have used it. And people in need of such high-rate loans aren’t spending a ton on discretionary items.

The fall in profits from lowering the legal maximum results from more than 90,000 fewer loans being made in the first year. The government acknowledges this will cause ripple effects – trouble finding replacement loans and therefore missed payments on other obligations, and the necessary seeking out of black-market lenders. But its suggestion that would-be borrowers turn to informal sources like family and friends does not have a great track record elsewhere. For example, only 40 percent of UK borrowers shut out by a similar cap were able to borrow from other sources.

Another problem is the reliability of the numbers. The government estimates there were 600,000 payday borrowers in Canada in 2021. In the United Kingdom, the number and value of loans dropped by more than half the year after its .08-percent daily – 29.2 percent annually – cap was implemented. If this holds true here, many more Canadians will be looking for alternative sources of credit than the government estimates.

Though the legislation focuses on payday lenders. it also catches regulated “alternative lenders” in its net. Though not included in the government’s analysis these lenders seem likely to reduce the supply of credit under the new cap, suggesting its true impact will be larger than reported.

Rather than trying to set the price in the market – which is always risky – the government should work to make the market for loans more competitive and transparent.

On transparency: Fees and terms need to be set as clearly as possible in the simplest language we can provide borrowers. How is the rate set? What happens if borrowers don’t pay on time? Requiring everything to be spelled out clearly will get rid of some of the bad actors.

On competition: If the government is right and Canadians are being taken advantage of with interest rates much higher than their risk profiles justify, why are competitors not jumping in to fill the gap? Open banking supposedly is coming to Canada to give consumers more choice, but somehow never arrives. Let’s get moving.

That many Canadians are forced to take out these kinds of loans says a lot about their financial situation. From a macro perspective, we need to improve the state of our economy. Many good ideas already exist to take advantage of our current trade crisis: Remove internal trade barriers, cut red tape, accelerate major project approval. These policies will bring more Canadians into good jobs that alleviate their credit pressure.

The government’s cost-benefit justification for lowering the interest rate cap is flawed. There are better ways to address predatory lending before resorting to price controls. Pick one, Ottawa. Better yet, pick them all.

Jeremy M. Kronick is vice-president of economic analysis and strategy at the C.D. Howe Institute.

To send a comment or leave feedback, email us at blog@cdhowe.org.

The views expressed here are those of the author. The C.D. Howe Institute does not take corporate positions on policy matters.

A version of this Memo first appeared in the Financial Post.