The Great Lending Loophole

High Interest Rates Are Illegal. So How Are Auto Lenders Getting Away With Them?

With regulations affecting everything from your tax bracket to the thickness of your storm windows, it’s reasonable to think they might also extend to protecting you from the kind of high-interest auto loan rates that have literally ruined millions of Americans’ lives.

And, in truth, there were laws written to do just that. They just don’t actually apply to the vast majority of institutions lending you money to buy your car.

How is that possible?

Basically, it’s because America’s interest rate laws have more loopholes than your grandma’s latest needlepoint project. Here’s the infuriating truth about how modern lenders are able to duck the very regulations designed to rein in sketchy and even downright oppressive loan practices.

Usury: The Funny Term With a Dark History

Start looking into lending practices of almost any era and the term “usury” will come up again and again.

It’s a term dating back to the Middle Ages that refers to the practice of lending money at a morally reprehensible interest rate. In these not-so-good-old days, you could literally be charged an arm and a leg (or the oh-so-literary pound of flesh) for the money you borrowed. Because of the general horribleness of this, kings and queens and even the church interceded to establish rules to prohibit the practice—or to at least try to make loan sharks who engaged in unfair lending feel guilty for the rates they charged.

Nowadays, of course, we have reams of banking regulations and entire organizations like the FDIC—created after the devastating effects of the Great Depression—to protect consumers from unfair financial practices. Unfortunately, when it comes to the lending industry, usury limits—the legal benchmark for the rates lenders can charge for certain products—are handled at the state level and vary widely by locale.

Interest Limits By State

Officially, the “legal rate of interest” ranges between 5 percent and 10 percent in most states. But some states, such as South Dakota and New Mexico, allow a legal rate as high as 15 percent.

In some cases, a state’s general usury limit is based on Federal Reserve interest rates; other times on that state’s own rules. For example, Pennsylvania decided it’s criminal to charge more than 25 percent interest, while Colorado and Oklahoma have a general usury limit of 45 percent. Meanwhile, Nevada and New Hampshire have no usury limits at all.

Lending Infographic

For Most, Interest Limits Don’t Matter At All

But the big problem with this system is that these limits don’t actually matter much at all since national banks were allowed to ignore them altogether in the wake of the inflation crisis of the late 1970s.

Jon Brodsky, a finance professional and author with Finder.com, said a single case effectively upended the entire banking system in 1978 when the Supreme Court ruled that a nationally chartered bank (including most credit card companies we’re familiar with today) can charge up to the legal interest rates of the state in which they’re located.

“As a result, states like South Dakota and Delaware changed their laws to essentially eliminate usury limits for credit cards, which generally includes store cards as well,” Brodsky said.

Nonetheless, Brodsky said some states have remained vigilant in maintaining fair lending rules.

“Today, New York is the most visible state in the country in terms of protecting its citizens from out-of-state usury, especially from non-bank institutions that are reliant on a bank’s federal charter to provide loans,” he said.

Predatory Short-Term Loans Can Be Brutal

Still, the big banks seem like angels compared to the absurd rates that payday and other “alternative” lenders can charge, said Donald E. Petersen, a consumer protection lawyer based in Orlando, Florida.

That’s because usury rules don’t apply to chartered organizations such as small loan companies, private auto lenders and even student loan servicers. Often, these organizations just need a license to exempt them from state usury limits, allowing them to charge whatever they want, to whomever they want.

Petersen said it’s also an issue of economics, as larger banks have pulled out of poorer neighborhoods, leaving residents essentially “unbanked.” Alternative financing companies, including personal loan vendors, payday lenders and other private lenders have filled that void. And for folks with non-existent credit ratings or other financial issues, it’s easy to become a victim of the system.

This is how a $5,000 personal loan can transform into a $42,000 debt despite there being clear laws intended to ward against such an occurrence. As the L.A. Times explains, a Southern California customer who agreed to a short-term loan found herself paying an outrageous 116 percent interest, super-sizing a small amount of money into an enormous debt—a move that’s totally legal on the lender’s part.

Usury Is Alive And Well

Tough state usury limits are obviously a good idea. But when they don’t have any legal teeth, lenders can charge whatever they want. Short-term payday loans, for example, can reach a staggering 700 percent annual percentage rate if you maintain a balance or miss payments and incur late fees—and then be layered on top of standard interest.

“In Florida, auto lenders can charge approximately 29 percent APR, and payday loan rates can amount to approximately 391 percent APR—and that’s legal under federal law,” Petersen said. “The Feds recently had to step in and cap interest rates on payday loans to active-duty military at 36 percent, after hearings demonstrating that the ‘market’ rates were interfering with military preparedness.”

But auto financing arrangements—especially those catering to at-risk buyers—also exist in the same gray area where usury limits don’t apply.

That leaves customers to fend for themselves when it comes to navigating outrageous interest rates.

“Access to credit of this kind is like giving starving people poisoned food,” attorney and consumer advocate Margot Saunders told the L.A. Times. “It doesn’t really help, and it has devastating consequences.”

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