Should interest rates be month-ized?

The idea behind APR – annualized percentage rates – is to put different interest rates into comparable terms. Some loans are for 2 months, say, and some for 2 years, so to compare them, it can be helpful to ask: “what would the rate be if the loan was for a year?”

Comparing apples to apples makes sense. Or at least that’s the financial industry/expert consensus.

Arjan Schutte is managing partner of Core Innovation Capital, a venture capital fund that invests in innovative financial technology aimed at the underbanked in the U.S. Arjan argues that APRs are misleading when it comes to short-term loans. Arjan points out that Americans took out $40 billion in pay-day loans last year (not including all the other types of short-term credit such as overdraft, pawn, etc.). Most of these loans are very short term, usually for emergency liquidity and a quick infusion of cash to meet short term needs. In that case, borrowers are thinking more about the dollar cost of the transaction than about the interest rate. 

The question for borrowers is: is this a fair price to pay to get cash now? They are definitely not thinking about the interest rate that pertains to a hypothetical one-year loan that isn’t among their choices. If they’re not thinking about APRs, why should we?

Arjan’s insight lines up with the findings in Portfolios of the Poor. The evidence in chapter 5 similarly shows that it is cash flow that matters most when people think about the cost of short-term loans, not APR.  Interest rates are often better understood as fees. But that insight is as far as we got.

Arjan suggests an alternative view, which he calls TRUST. He puts it forward as a new standard for short-term credit. These are the elements:
•    Term flexibility: suit the loan to fit various users’ needs
•    Repaid fully: design the loan to be payable without destructive rollover
•    Understandable: make the terms and fees clear and transparent to real people
•    Selective: good loans are priced according to narrower risk assessment categories
•    Transitional: offer a graduation path for good performance 

Those seem like a reasonable set of principles, and Arjan says that “TRUSTed loans are not just significantly more consumer friendly, by addressing a loan’s structure, but also encourage sorely needed industry innovation.” 

That’s all good, but it doesn’t solve the initial problem: how to compare prices on loans?  After all, consumers do need a way to think about prices.  If the APR doesn’t capture the right frame for short-term loans, what should replace it?  Putting every loan that’s shorter-term than 6 months into 1-month terms?  We’d then compare MPRs, Monthized Percentage Rates. It sounds ugly, and it’s still arbitrary – and it’s probably not even a word.  But it makes far more sense than APRs in terms of the short-term choices being made by many borrowers.