Access to credit is essential. But when lenders operate through a business model that overwhelmingly turns small loans (think $500) into insurmountable cycles of debt, they are not providing an essential service and are instead profiteering. Such is the case with the payday loan and related short-term credit markets in the United States. Today, the Consumer Financial Protection Bureau (CFPB) unveiled new proposed rules designed to improve the practices of these lenders that draw customers into cycles of debt. The aim of the rules isn’t to kill essential access to credit, but to rein-in the payday loan industry’s reliance on having a high percentage of borrowers who are unable to repay their loans and are drawn-in to repeat borrowing at higher rates and with additional fees.
There are more payday storefronts than McDonald’s restaurants in the United States. Across storefront and online lenders, there are roughly 16,000 providers serving over 19 million American households. In the U.S., payday loans typically have an annual interest rate of 390 percent or more, according to the CFPB. These loans are purportedly designed to hold borrowers over between paychecks or short periods of time. Similarly, single payment auto title loans, which use borrowers’ vehicle titles for collateral, hold an annual interest rate of about 300 percent, and are typically to be repaid within 30 days. However, the vast majority of these loans aren’t repaid in the time allotted. Considering both payday and auto title loans, four out of five borrowers aren’t able to repay their loans during the time allotted and have to renew their loan or take out another loan to cover the first one. Such actions incur additional fees and interest, and build a long-term debt trap for borrowers.
In the United States this problem causes great hardship: more than one-third of payday installment loan sequences and nearly one-third of auto title installment loan sequences end in default; 25 percent of car title loan customers have their cars seized; and last year the fees associated with customers needing to take out new loans to cover previous ones grew to $3.5 billion.
In addition to typical payday and auto title lenders, the CFPB’s new proposed rules apply to online lenders, deposit advance loans, and certain high-cost installment and open-end loans. Only consumer loans are involved, because CFPB’s authority does not extend to small businesses, although it is certainly the case that many people use personal loans for business purposes.
Key elements of the rules are:
- The full-payment test: Under the new rules lenders would have to determine whether borrowers can afford their payment obligations without bringing on other financial hardships. They would have to verify income and check existing debt service requirements. One measure of repayment capacity for a payday loan is that a person would not have to re-borrow to repay the loan within 30 days. The rules also propose limiting the number of short-term loans that can be made in quick succession.
- Principal payoff option for certain short-term loans: For loans of $500 or less, the above requirement is waived. Furthermore, provided borrowers retire at least one-third of their debt each time, up to two extensions of the loan would be allowed.
- Less risky, longer-term lending options: This proposal offers lenders two ways to avoid some regulation by offering one of two alternative versions of a short-term loan. The first option would be offering loans that generally meet the parameters of the National Credit Union Administration “payday alternative loans” program. The other option would be offering loans that are payable in roughly equal payments with terms not to exceed two years and with an all-in cost of 36 percent or less, not including a reasonable origination fee, so long as the lender’s projected default rate on these loans is 5 percent or less.
- Debit attempt cutoff: To deal with a related problem often encountered by payday borrowers – overdraft fees – lenders would have to give consumers written notice before attempting to debit the consumer’s account to collect payment. After two failed attempts, the lender would be prohibited from debiting the account without new authorization from the borrower.
The proposed rules are very much in keeping with the practices the Smart Campaign has championed. Its standards on avoiding overindebtedness require repayment capacity assessment, including a look at income, expenses and debt service. Its responsible pricing standards call for avoiding excessive fees, especially penalty fees. And the Campaign standards wave a red flag when the structure of a business model incorporates frequent default as an expected outcome.
The federal government is not the only actor going after payday lenders. Last month Google banned ads from payday lenders, and about a dozen states have issued their own rate caps and rules clamping down on the industry.
Today’s announcement involves a proposal, not a fait accompli. CFPB will be accepting comments on the proposed rules all summer before publishing the final regulations in the autumn. We are sure to see a wide array of evidence marshalled both in favor and against, and a not a few hot tempers on both sides. The first element of the rules – the Full Payment Test – is the most contentious piece. It requires significantly more underwriting and diligence/documentation on a customer than loans typically require today. This will not only increase the cost to provide these loans, it will also mean that the underwriting process is longer, potentially negating the speed and convenience benefits of payday loans.
Today the CFPB also launched an inquiry into other potentially high-risk loan products and practices that are not specifically covered by the proposed rules.
For more information on both the new rules and inquiry, and to offer your comment, click here.
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