Federal regulators proposed ambitious rules on Thursday that would require payday lenders to consider borrowers’ ability to repay and limit the number of repeat loans. When final, the rules would radically change the way lenders make loans to an estimated 12 million people a year.
“Too many borrowers seeking a short-term cash fix are saddled with loans they cannot afford and sink into long-term debt,” says Richard Cordray, director of the Consumer Financial Protection Bureau.
The CFPB, which opened a three-month comment period on the proposal, says the rules could curb some of the worst practices in the $38.5 billion industry. The changes would make it harder to make loans that borrowers clearly can’t afford to repay, a practice that has trapped many people in a prolonged cycle of debt and that subjects them to repeated penalties for failed payment attempts.
“The business model of exploiting desperate people with few resources needs to be disrupted,” says Liz Weston, NerdWallet personal finance columnist. “These rules are a good start.”
Yet some consumer advocates say the rules don’t go far enough in addressing interest rates that routinely reach triple digits. And payday lenders say the rules could further squeeze access to credit for the people who need it most urgently.
Changes for payday loans and their look-alikes
The most visible form of payday lending comes from a storefront that offers a high-interest loan without checking a borrower’s credit, with repayment due on the borrower’s next payday. The cost is often represented as a fee: $15 per $100 borrowed is typical, the CFPB says, so on a $350 loan for two weeks, the fee would run $52.50. When expressed as an annual percentage rate, the interest rate on that $350 loan is nearly 400%.
Borrowers who can’t repay the loan can simply renew it and pay the fee again. The CFPB says its research showed that 90% of the industry’s fees came from consumers who borrow seven or more times.
A patchwork of state and federal regulations has evolved over the years to address concerns over payday lending. The District of Columbia and 14 states outlaw payday lending altogether. Other states allow it but apply various rules that may limit the amounts consumers can borrow or how many times they can renew.
Those regulations have led lenders to seek new avenues for high-interest lending, such as:
- Online payday loans: Lenders operate websites instead of physical storefronts, which allows them to evade state interest rate limits. Most require electronic access to the borrower’s bank account, which leads to repeated overdrafts and account closures.
- Auto title loans: Lenders hold the title to a vehicle in return for quick cash, with average interest rates of 300%. A CFPB study found that half of all loans were recycled 10 or more consecutive times, and 1 in 5 of those borrowers eventually lost their vehicles.
- Payday installment loans: These loans are repaid over time rather than in a lump sum, but carry the same triple-digit interest rates and requirement for access to a borrower’s bank account as traditional payday loans. They often advertise as no-credit-check loans.
What the CFPB rules would do
Broadly, the CFPB rules address three widespread concerns about the payday, auto title and high-cost installment loan industries:
- Ability to repay: For loans of more than $500, lenders would be required to check the borrower’s credit history upfront and see if the borrower can afford to repay the loan after meeting all other debts and obligations. If a borrower cannot afford to pay back the loan without having to re-borrow within 30 days, the lender cannot make the loan.
- Repeat borrowing: For loans of $500 or below — the average payday loan is $375, according to a study from Pew Charitable Trusts — lenders would not have to perform the ability-to-repay test. But they would not be able to lend to a borrower who has other outstanding small-dollar loans. Once a loan is made, a lender could offer a borrower up to two extensions, but only if the borrower pays off at least one-third of the loan amount with each extension. Lenders also would not be allowed to take an auto title as collateral with such loans.
- Harmful debit practices: Lenders would be required to give borrowers written notice before trying to debit their bank accounts for payment. After two failed collection attempts, they would be required to seek the borrower’s permission again.
Regulators have estimated that as much as 80% of current payday lending volume could disappear under the proposed rules, which could be ready for implementation some time in 2017.
A spokesman for the Consumer Financial Services Association of America, a payday lending trade group, says the rules would create “financial havoc” in the communities that rely on them.
“The bureau has prescribed a rule that fits its predetermined conclusions and will actually harm consumers’ financial well-being,” says Dennis Shaul, the group’s CEO. “What is missing in the bureau’s rule is an answer to the very important question: Where will consumers go for their credit needs in the absence of regulated nonbank lenders?”
Shaul predicts thousands of lenders would shut their doors.
What the rules won’t change
The one aspect of payday lending that won’t change is the high interest rate. The CFPB doesn’t regulate interest rates; states do.
Most consumer lending is done under a broadly accepted 36% APR rate cap. Lenders say it’s hard to make money at that rate from very small loans repaid in a few weeks or months, yet those are the kinds of loans consumers without access to other types of credit need. That’s led some states to carve out exceptions that allow payday lending and auto title loans to flourish by charging much higher rates.
Consumer advocates say banks could help fill the need for small loans if they had clear and simple underwriting standards that were more in line with existing underwriting methods. But one group says the proposed rules make underwriting for banks more complex and therefore costly.
“Installment loans at 400% APR are still harmful even with more underwriting. Strong CFPB rules are badly needed, but this proposal focuses on the process of originating loans rather than making sure those loans are safe and cost less,” says Nick Bourke, director of the small-dollar loans project at the Pew Charitable Trusts.
Clear product safety standards, such as limiting installment loan payments to 5% of a borrower’s paycheck and a six-month repayment term, would allow banks and credit unions to step in and offer small-dollar loans at much lower rates, according to Pew.
Alternatives to payday loans
High-cost lenders have long been a go-to source of cash for borrowers who either lack credit history or have credit scores too low to qualify for traditional lending. TransUnion, for example, says 43% of millennials have VantageScores below 600, the level generally needed to find a loan at less-than-catastrophic interest rates.
Reputable, nonpayday lenders charge a maximum annual percentage rate of 36%, and they check a borrower’s credit score, credit history and debt-to-income ratio before extending a loan. Some also take into account nontraditional factors such as a borrower’s education and profession. A few online lenders cater to those with poor credit or allow borrowers to add co-signers in order to qualify or to get a better interest rate.
There are other options for those who do not qualify for traditional forms of credit.
Many credit unions offer small-dollar loan products at lower interest rates than a payday lender. The maximum APR at federal credit unions is 18%, though rates at state institutions may be higher. Generally loan amounts are $200 to $1,000 with repayment from 30 days to six months, with fees no more than $20. They cannot be rolled over.
In addition, nonprofits, religious and community organizations may be able to offer financial assistance. Residents of California and Texas can search NerdWallet’s payday loans alternatives database for local organizations that offer small-dollar loans.
Research from the Urban Institute has shown that as little as $250 in savings is enough to prevent a family from missed bill payments, eviction or having to receive public benefits.