The Truth, the Whole Truth, and Nothing but the Truth: Fulfilling the Promise of Truth in Lending

Abstract

Evaluating the cost of credit and comparison shopping in the modern credit environment can be a daunting task, even for the most sophisticated shoppers. Lenders increasingly unbundle the costs of their loans from the interest rate into an array of fees, outsource their overhead to third parties who add to the consumer’s cost, and unveil amazingly complex loan products that dazzle and confuse borrowers. At the same time, the preemption of state usury and consumer protection laws by Congress and the federal banking agencies spurred deregulation at the state level. Today, the consumer credit marketplace is governed almost exclusively by disclosure rules. The subprime mortgage crisis of 2007 resulted from allowing the market to police itself and from the failure of disclosure to curb abuses.

Nearly forty years ago, Congress addressed the problems caused by lack of transparency in credit pricing when it enacted the Truth in Lending Act (TILA). Congress intended to promote informed consumer shopping and a level playing field for lenders by requiring standard disclosure of the cost of credit, most simply through the annual percentage rate (APR) and the finance charges upon which the APR is based. The value of the APR disclosure has deteriorated since 1968 due to exclusions from the finance charge definition created primarily by the Federal Reserve Board.

The article documents the history of this decline for the first time and describes the consequences of an APR disclosure that has become incrementally weaker as an indicator of the true cost of the credit. This article draws upon financial literacy, cognitive psychology, and behavioral economics literature to justify the need for a more effective APR.

The authors posit a simple litmus test for the finance charge that creates a more effective APR. They discuss why this test is superior to other proposed definitions of the finance charge and respond to arguments that a fee-inclusive APR is unhelpful to consumers and harms the industry.

This article is particularly timely because the Federal Reserve Board is currently undertaking a sweeping overhaul of TILA disclosure regulations, including the finance charge definition. Given the state of the credit marketplace, the authors conclude that a robust APR is more critical now than it was in 1968.

Keywords: credit, borrowing, preemption, usury, Truth in Lending Act, TILA, finance charge, Federal Reserve Board