Loan Contracting in the Presence of Usury Limits: Evidence from Automobile Lending

Abstract:

We study the effects of interest rate ceilings on the market for automobile loans and find, surprisingly, that binding usury limits do not lead to rationing of high-risk borrowers. Instead, loan contracting and the organization of the loan market adjust to facilitate loans to risky borrowers. When usury restrictions bind, automobile dealers finance a greater share of their customers’ purchases, which allows them to price credit risk through the mark-up on the product sale rather than the loan interest rate. Despite having little effect on who receives credit, usury limits therefore have a substantial effect on who provides credit and on the terms of credit granted. By encouraging dealers to price credit risk through product mark-ups, usury limits may hinder enforcement of fair lending laws and harm defaulting borrowers, who face greater liabilities in default than they would if loan contracts were unconstrained.