[Journal of Finance, May 1960]

CONSUMER FINANCE

RECENT TRENDS IN STATE REGULATION OF
INSTALMENT CREDIT*

WALLACE P. MORS

Babson Institute of Business Administration

STATES HAVE been very active in initiating, extending, and modifying their control over instalment credit since the end of World War II. Significant trends include (1) a marked increase in the number of retail instalment financing laws; (2) a start of a movement to control credit insurance; (3) amendment of a number of consumer finance laws to permit precomputation and higher loan limits; (4) spread of insurance anticoercion laws; (5) start of a movement to prohibit the debt prorating business; and (6) start of a movement to control revolving credit.

Perhaps the most significant trend has been the spread of retail instalment financing laws to thirty-three states. Twenty-five states have adopted such laws since World War II, and several others have modified previously existing laws in the same period. Since it is impossible to cover all aspects of these laws or of the other five trends mentioned above, in the space allowed, I have chosen to concentrate on the finance charge (rate) control aspect of retail instalment financing laws.1

Postwar legislative activity has definitely established the principle of finance charge control in retail instalment financing. Whereas only two of the eight pre-1946 laws set maximum finance charges, twenty-seven of the thirty-three existing laws set such maximums. Twelve of the laws set maximum finance charges for all retail instalment financing transactions and fifteen for automobile transactions only.

* This paper by Wallace P. Mors and the following paper by Carl A. Dauten were presented at a meeting of the American Finance Association in Washington, D.C., on December 29, 1959. The program was under the chairmanship of Clyde W. Phelps, University of Southern California.

1. For a detailed descriptive account of all aspects of retail instalment financing laws see William E. Hogan, "A Survey of State Retail Instalment Sales Legislation," Cornell Law Quarterly, Fall, 1958, pp. 38-73. For an earlier account see Wallace P. Mors, "State Regulation of Retail Instalment Financing-Progress and Problems," Journal of Business, October, 1950, pp. 199-218 and January, 1951, pp. 43-71.

The trend toward finance charge control is inevitable and results basically from several forces. First is the existence of excessive charges when control does not exist. Second is the demonstrated effectiveness of control in reducing excessive charges in the consumer instalment cash lending sphere. Third is the essential similarity between retail instalment financing and instalment cash lending. This similarity has been emphasized in recent years by a growing tendency of courts to rule that retail instalment financing transactions come under the usury laws. Such rulings make special finance charge control virtually mandatory, for most usury limits are adequate for new-car financing but are inadequate for used-car and other-commodity financing.

A contributing force since 1956 has been the changed sentiment of a large segment of the sales finance industry toward legislation. The American Finance Conference, a trade association of sales finance companies, passed a resolution favoring legislation in November, 1956. With this resolution the conference moved into a third stage in its attitude toward regulation. The first stage was hostility, and the second was neutrality. In approving the principle of legislation, the conference stated that, to be adequate, legislation should contain a number of specific provisions, including maximum finance charges.

Now that the principle of finance charge control has been established, we need to ask whether the maximums which have been adopted to date stand a chance of accomplishing the purpose for which they are presumably intended. This purpose is to make credit available to instalment buyers at reasonable rates, i.e., rates which give financing agencies a legitimate profit in terms of the risks that these agencies assume. I shall concentrate my attention mainly on existing new-car maximums, because more information is available on new-car financing than on used-car and other-commodity financing and because new-car financing is the most important dollar segment of retail instalment financing.

PRESENT NEW-CAR MAXIMUMS

In its 1957 annual report, General Motors Acceptance Corporation (GMAC) stated: "In some instances they [maximum allowable finance charges] seem unduly high, or, at least, not sufficiently low to eliminate unfavorable comment, even though approved by the duly elected representatives of the people." Most states set ceil

2. Control will not eliminate excessive charges, of course, if legislative maximums are set too high.

ings in terms of annual add-on rates; a few use monthly rates on the original contract balances; and a few use monthly rates on the unpaid balance. Table 1 shows annual add-on rates, or their equivalents, for new-car financing in 1957 and at present. Annual effective finance charge rates are roughly double annual add-on rates, computed on a time-money basis.

The maximum annual add-on limits in Table 1 vary from 6 to 12 per cent. Twenty-five of the limits are 7 per cent or higher and fourteen are 8 per cent or higher. Table 2 gives the distribution of newcar add-on rates which were charged by dealers in the late spring of 1956. This indicates that (1) the median add-on charge was 6 per cent, (2) 70 per cent of the reporting dealers charged 6 per cent or less, (3) 88 per cent charged 61 per cent or less, and (4) only 2 per cent charged more than 7 per cent. This raises several questions. Since the charge of most dealers was 6 per cent or less, can states justify limits above 6 per cent? If so, what excess over 6 per cent can they justify? What, if any, effect will the limit have on actual charges?

Answers to these and other questions require much more data and knowledge than we now possess. Some exploratory comments are worthwhile, if only to call attention to all the implications involved in setting finance charge maximums.

DIVISION OF THE FINANCE CHARGE

Retail instalment financing laws cover instalment credit transactions initiated by dealers (sellers). They do not cover instalment cash loans made by banks or other lending agencies to enable consumers to buy autos or other commodities. The interest on instalment cash loans goes wholly to the bank or other lending agency. The finance charge on dealer-originated credit transactions is usually divided between the dealer and the financing agency which buys the credit (instalment paper). The part of the finance charge which 3. Median effective new-car finance rates by region were as follows in 1954 and 1955:

These data indicate that geographical variations in financing conditions cannot support the wide spread in add-on limits. The above figures are from Consumer Instalment Credit, Financing New Car Purchases (New York: Federal Reserve System, 1957), Part IV, p. 74.

4. Usury, small-loan, credit-union, and industrial banking laws set maximums for cash loans.

* Some states express maximum allowable rates in monthly terms. California, Nevada, and Utah have a maximum rate of 1 per cent of the original contract. This is an equivalent yearly add-on rate of 12 per cent. Iowa, Louisiana, and South Dakota have a maximum rate of 1 per cent a month on the unpaid balance. This is an equivalent annual add-on rate of about 7 per cent.

One of these states, Ohio, has an add-on rate of 8 per cent plus extra charges which bring the actual add-on rate equivalent to about 9 per cent.

Indiana's law permits equivalent add-on rates of from roughly 10 per cent on 12-month contracts to 81 per cent on 36-month contracts.

TABLE 2*

DEALER REPORrts of Customer Rates in NEW-CAR FINANCING,
BY TYPE OF FINANCING AGENCY, LATE SPRING, 1956

PERCENTAGE Distribution of NUMBER OF REsponses
WITHIN FINANCING AGENCY GROUP

Source: Consumer Instalment Credit, Growth, and Import (New York: Federal Reserve System, 1957), Vol. I, Part I, p. 53.

Note: Rates have been rounded upward to multiples of per cent. If a dealer reported a range, the charge was recorded at the mid-point rounded upward to the nearest multiple of per cent. Details may not add to totals because of rounding.

tRates are add-on finance charges stated in percentages per annum of unpaid original balance, and not effective or "true" interest rates.

* Averages are weighted by number reporting.

the dealer gets is variously called "dealer participation," "dealer reserve," or "dealer bonus."

A Federal Reserve study shows that the following median effective annual new-car rates existed in 1954 and 1955:5

The study reports that "the higher rates on paper purchased by banks and sales finance companies than on direct loans may be explained partly by differences in average risk, and partly by 'dealer reserve' arrangements often made in connection with purchased paper.

A prewar study further clarifies the relation of dealer participation and the finance charge. Table 3 presents the Federal Trade Commission's findings on average annual new-car add-on finance charges for the 1936-38 period for three classes of finance companies. The data show that average rates were 6 per cent for GMAC, 6 per cent for CIT Financial Corporation and Commercial Credit, and slightly over 7 per cent for other finance companies. The FTC report stated that these variations were caused mainly by the different ways in which the three classes of companies handled dealer participation. GMAC rigorously controlled dealer participation by disallowing packs. The other companies were less effective in this respect. As a result, the dealer portions of the finance charges for the three classes of companies shown in Table 3 were, successively, 19.5, 30.0, and 25.2 per cent.

In a consent decree signed in 1952, General Motors agreed not to coerce dealers to patronize GMAC or any other specific finance company. While General Motors denied ever having done any coercing, GMAC has shifted from its prewar policy in handling dealer financing. GMAC's objectives presumably are the same as before, i.e., to get the maximum financing business from General Motors 5. Consumer Instalment Credit, Financing New Car Purchases, 6. Ibid.

7. This was the pre-regulation period.

P. 74.

8. Packs in transactions handled by the factory-preferred and independent companies were actually greater than shown in Table 3; for, through the use of multiple-rate charges, packs are concealed in the amounts shown as loss reserves and bonuses (see Federal Trade Commission, Report on Motor Vehicle Industry [1939], p. 967).