The Consumer Financial Protection Bureau (CFPB) Proposes Regulations for High-Cost Small-Dollar Lending
New proposed rules could rein in some of the worst offenses, but do they go far enough?
Typically, having repeat customers means a business is doing something right. In the case of payday and other high-cost small-dollar lending, however, repeat customers are a sign that the business is doing something very wrong: namely, purposefully trapping low-income borrowers in high-cost loans. Payday loans in Indiana carry more than 300% annual interest and they typically require balloon payments totaling one-third or more of a client’s paycheck. They also give the lender “preferred repayment access” either through direct withdrawal capabilities from a client’s deposit account or, in some states, through the ability to seize a client’s car title. Before the lender deducts the balloon payment on payday or seizes the borrower’s car, the borrower is often required to borrow again to make ends meet. In fact, more than 75 percent of payday loan fees are from borrowers taking on more than 10 loans a year. This has enabled payday lenders to extract billions annually from people making, on average, $25,000-$30,000 per year.
Consider the following scenario. A consumer borrows $250.00 to help pay the rent when he receives fewer shifts than expected, and in Indiana, this can carry a fee of $37.50. This is approaching 400 percent Annual Percentage Rate (APR). On payday, the lender is entitled to deduct $287.50 from the client’s checking account. If, on that day, the consumer cannot afford to repay the entire loan and meet his expenses for the following two weeks, he has one of two options. In states that allow rollover, he can pay the $37.50 fee and receive another 14 days to repay $287.50. In states that limit rollovers, lenders withdraw the full amount due and the consumer can immediately seek a new loan with new fees. In either case, the impact to the borrower is the same: an unaffordable cycle of debt.
Borrowers enter into debt for a variety of reasons, but in terms of payday loans, a couple of trends stand out. According to one research report, up to one-third of borrowers found themselves caught in a desperate situation and report that they would have taken a loan at any cost. Others hoped the fixed fee and short loan term would help them avoid going into long-term debt. Though borrowers often express a sense of relief at having access to quick cash to pay bills, polling among payday borrowers also finds that 72 percent of payday borrowers favor more regulation. More broadly, another recent poll suggests 92 percent of American voters believe it is important to regulate financial products.
What is the Consumer Financial Protection Bureau doing to protect borrowers?
After engaging in several years of research, supervision, and enforcement actions, the CFPB has created a set of proposed rules to help protect borrowers from unaffordable, high-cost payday loans, car title loans, and high-cost installment loans. The CFPB has proposed rules for short-term loans (defined as 45 days or less) and for certain longer-term loan products (excluding loans with 36 percent all-in APR or less, vehicle purchase loans, student loans, and credit cards). For both of the loan types covered by these new rules, lenders can either assess an individual’s ability-to-repay or meet an alternative set of requirements, as outlined in the table here.
In the initial draft of the proposed rules, the CFPB also offered an alternative requirement that some longer-term loans whose payments were no more than five percent of a borrower’s income would not be subject to the ability to repay test. This CFPB removed the five percent payment-to-income (PTI) ratio from the June 2 proposal. One reason may be that the CFPB found high default rates on loans at this level (28-40 percent), although bank and credit union default rates are expected to be much lower. Many consumer advocates are thankful the CFPB made this particular change to the rule. However, others are concerned that the removal of this alternative requirement will keep banks and credit unions – whose fees are typically 6-8 times lower - from entering the marketplace due to the costs associated with ability-to-pay verifications, and call for replacing the 5 percent PTI alternative, noting that the ability-to-repay provision – in the absence of more stringent determinations of what a “reasonable” determination looks like – will likely allow for loan payments much higher than five percent.
Finally, the proposed rules also identify repeated withdrawal attempts after two failed payment attempts as abusive practice, and prohibit lenders from making multiple withdrawal attempts without first obtaining new authorization from the account holder. Lenders must also give advance notice of upcoming withdrawal attempts.
Are the rules sufficient?
The ability-to-repay concept helps to pull payday lending in line with the general ethic of responsible lending. However, there are several weaknesses. First, the rules leave it up to payday lenders to determine a “reasonable” estimate of a consumer’s budget under the ability-to-pay provisions and set the monthly payment and loan term based on their projections. Lenders will have strong incentives to provide low estimates of consumers’ expenses in order to classify a larger proportion of an individual’s income as “disposable,” and are already finding creative ways to do so. The lender could also set a small payment but stretch the loan term out for a year or more to drive up the total cost of the small loan. At the same time, the alternative provisions essentially exempt six costly payday loans from the ability-to-repay provision. These high-cost, lump-sum loans can also consume a large proportion of a borrower’s paycheck, resulting in a likelihood that the borrower will take on new debts, default on other payments, or wind up in bankruptcy. During the open comment period, organizations can call on the CFPB to strengthen both the ability-to-pay verification process and the alternative provisions. The open comment period closes October 7, 2016.
Also, while the CFPB is not able to set interest rate caps, which may be the most effective way to stop debt traps, states do have this power. Indiana limits small-dollar loans to $605.00, requires 14 days to repay, and limits finance charges. However, these limits still enable payday and other small-dollar lenders to charge an APR above 350 percent. Last session, lenders pushed for an expansion of this statute to increase the loan amount, repayment terms, and finance charges. Thanks to consumer advocates, this bill was defeated in committee. Sign up for Indiana Institute for Working Families’ Action Alerts to receive notice next session if payday lenders attempt to put forward new legislation.
Finally, payday and other small-dollar lenders exist in large part because low-income families face rising costs with inadequate incomes. One in three Hoosiers lives below economic self-sufficiency, meaning that families are straining to live on a budget that leaves no margin for life’s inevitable curveballs. Strengthening wages and work supports to ensure that families can meet their basic needs, build emergency savings, and acquire assets like a home or a post-secondary certificate or degree is the ultimate solution to eliminating debt traps.
Still, the CFPB’s proposal is a step in the right direction. Repeat business at any lending establishment should be the result of quality products and services, not deceptive or unaffordable loans. Hopefully the finalized rules, which will be released in 2017, will push the payday loan market toward more responsible lending, providing liquidity to low-income Hoosiers without ensnaring them in an endless cycle of high-cost borrowing and repayment options.
With thanks to Diane Standaert, Center for Responsible Lending, & Gabriel Kravitz, Pew Charitable Trusts, for their valuable feedback on this publication.