September 15, 2016 in Personal Loans

For borrowers with good or excellent credit, personal loans are relatively easy to come by and very cheap to finance.

But several court cases and potential government regulation could make personal loans harder to get for consumers with damaged credit. One closely watched case already has had an impact in 3 East Coast states.

These borrowers wouldn’t qualify for today’s top rates anyway, but now they may be pushed out of personal loans altogether and into higher interest payday loans.

“Subprime and near prime borrowers are the ones who have fewer options available to them to begin with,” says Brian Knight, a senior research fellow for the financial markets working group at the Mercatus Center at George Mason University in Fairfax, Virginia. “The odds are better that their next best options are marginally worse.”

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In Bankrate’s national survey of interest rates from banks and thrifts for Sept. 14, 2016, the rate on personal loans remained at their low point for the year at 10.68%.

This week’s average rate is down nearly three-quarters of a percentage point from its 2016 high. A year ago, interest on the average personal loan was 11.12%.

The lawsuit many are watching

In June, the U.S. Supreme Court declined to review a lower-court ruling in a case involving a woman who opened a credit card with one bank (which later sold her account), defaulted on the card and later sued the servicer that attempted to collect the debt at an interest rate of 27%.

The Madden vs. Midland Funding ruling held that when a bank sells a loan to a non-bank, the new owner may not be able to charge the same interest rate as the bank had. Instead, the new owner must obey the interest rate cap, or usury, laws of the state in which the borrower resides. (A California judge last month handed down a ruling with some similarities, as well.)

This is not how banks typically have to operate when they sell loans to other banks. The rate set by the issuing bank remains in force.

For marketplace lenders — which are not explicitly affected by this ruling — there still remains a good deal of uncertainty about whether they will be able to charge interest rates going forward high enough to offset the risk of lending to borrowers with weaker credit scores. So marketplace lenders — non-bank online lenders who match borrowers with investors, but who may partner with banks to originate loans — cut back.

Following the Madden ruling (the full case is still pending), personal loans originated by marketplace lenders declined by 48% for borrowers living in Connecticut, New York, and Vermont with a FICO score below 625, a May 2016 study found. Meanwhile, loan volume grew 124% for borrowers living outside the 2nd Circuit of the U.S. Court of Appeals, in which the ruling was made.

As a result of the ruling, marketplace lenders “were less likely to provide and originate loans to these borrowers,” says Colleen Honigsberg, an assistant professor of law at Stanford Law School and one of the authors of the study. “What really matters is that the loan was going to be over the usury rate.”

In some states, that rate is no higher than the typical interest rate you’d pay on a credit card. In New York, for example, the usury rate is 16%, well below the 30% APR some online lenders charge consumers with weak credit.

Honigsberg says she’s unsure if the 3 unnamed lenders in the study have continued to shy away from low credit score borrowers since the conclusion of the study.

Solutions ahead?

Whether other lawsuits become the test case the Supreme Court ultimately decides to take up is unclear, Knight says. Legislative remedies also appear uncertain, although there is at least one bill that has been introduced in Congress.

Some lenders also have changed their lending models to try to clear up the uncertainty, but they are working against diverse state and national laws, which may prevent lenders from offering a one-size-fits-all product to borrowers, Knight says. The Treasury’s Office of the Comptroller of the Currency may offer up future regulations, but it’s unclear whether that will make either lenders or borrowers happy.

Knight says he worries the government could step in and set a regulatory burden too high for marketplace lenders to meet.

“My concern is that at the margins, unnecessarily restrictive regulation is going to kill it,” he says.

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