Thinking about interest rates

Interest rates on credit cards seem very high, and apparently are increasing during this period of economic hardship. Other unregulated sources of short term credit, such as bank overdraft charges and streetfront check cashing services which provide advances on paychecks have even higher rates. It occurs to me to think a little in public about interest rates.

Interest has to cover:

• Transaction costs, including the costs of obtaining the funds to loan out and the costs of making loans and collecting repayments
• The cost of the money to be loaned, including the interest that the financial institution has to pay on money it borrows and the return it must provide to the investors providing its capital
• The time value of money, since the amount repaid should be sufficient to buy the same market basket of goods and services as that loaned (and thus adjusted for inflation) and a premium to the lender for deferring consumption for the duration of the loan
• The cost of loans that are not repaid

In hard times, as more borrowers default on their loan repayments and as collateral loses value, the risk increases. As risk increases not only must interest rates increase to cover more defaults but investors and depositors also demand higher returns to better cover their own increased risks. All of this suggests that interest rates may legitimately be increased in hard times.

On the other hand, it seems obvious that there is the potential for lenders to take unfair advantage of people in economic need by charging unfairly high interest rates. Developing nations are full of reports of people kept in debt by gouging lenders who enforce debt traps for the poor.

As a result there are many laws on the books that place limits on usary rates and require disclosure of information to borrowers. It appears however that the financial industry is opposing new regulation of the relatively new financial instruments that have come into much wider use in recent decades. What would be the impact of limits on interest rates or on hidden interest rates such as charges on overdrafts?

Companies would perhaps cut transaction costs and profits, but they would also seek to avoid the higher risk lending that they have been doing. Less credit to high risk borrowers would create hardship for many of those most in need of loans, but given the high rates of debt in the United States might be useful for the economy as a whole.