For many Americans struggling to make ends meet between paychecks, a single loan can snowball into crippling, long-term debt. A small loan of just a few hundred dollars can quickly amass fees and put consumers’ financial survival at risk. And yet, the advent of a certain type of loan—known as the “payday” loan—has, by many accounts, made this problem a harsh reality for millions of Americans.
“Payday” loans, which typically charge a $15 fee for every $100 borrowed, are high-cost, short-term loans commonly used by low-income borrowers with impaired credit. Although the average payday loan amounts to just $350 for a 14-day period, these small loans are severely challenging for low-income borrowers, not only because of their ultra-high interest rates, which can exceed 300 percent, but also because of the payment mechanism embedded in their terms. Borrowers are typically required to pay the lump-sum when the loan is due, an especially tall order for income-volatile consumers. Unable to pay the lump sum, many consumers take out another loan to pay off the first one—spurring a cycle of loan after loan, with the average borrower taking out 10 payday loans per year just to keep the initial amount afloat.
To tackle this growing issue of short-term, small-dollar loans, the Consumer Financial Protection Bureau (CFPB) recently proposed a rule that would establish consumer protections for borrowers taking out payday and similarly structured loans. The rule would impose new restrictions on lenders, and it would require them to make a reasonable determination that the borrower has the ability to repay the loan, and then to obtain a borrower’s specific authorization to withdraw payment from an account after two consecutive payment attempts have failed.
Alternatively, the rule would allow lenders to make loans without assessing the borrower’s ability to repay as long as they structure the loan to have caps on the maximum loan amount, interest rate, and duration. As it stands, the proposed rule would apply to two types of loans: short-term loans, such as payday loans, and longer-term loans that have especially high interest rates and that threaten either a borrower’s bank account or car title.
The proposed rule marks the first time that the CFPB has attempted to regulate payday and similarly structured loans. Before the creation of the CFPB in 2010, payday loans and other short-term small loans were largely regulated by states, with minimal federal intervention. This state-dominated approach gave rise to a patchwork of payday lending practices—and which, even after the CFPB’s creation, has remained in place—with one 2013 report from the Center for Responsible Lending noting that 29 states have no substantive restrictions on payday lending whatsoever, while 21 states and the District of Columbia have either restricted or eliminated payday lending practices altogether.
Now, with all eyes on the federal government’s first attempt to regulate a $15.9 billion industry, policymakers and industry experts alike have been vocal in debating the merits of the proposed rule. The Pew Charitable Trusts’ Small Dollar Loan Project, in particular, has been one of the few non-industry groups to oppose the rule.
One potential problem that the proposed rule poses is that although it would reduce the number of short-term payday loans, it would do nothing to address the growing practice of “installment lending,” Nick Bourke, the director of the Small-Dollar Loan Project, reportedly has stated. With nothing to stop lenders from shifting to nominally different but functionally similar loans, Bourke recommends that the rule be revised to include a payment standard based on reasonable, small-installment payments. Under such an approach, a borrower would pay off a $500 loan over six months—rather than over a two-week pay period—with each payment capped at 5 percent of a borrower’s paycheck.
But advocates of the lending industry argue that the rule would force thousands of small lenders out of business and cut off the only channel of credit that is open to low-income borrowers. Further, demand for these loans remains high, with one 2014 study from the Federal Reserve Bank of St. Louis estimating that there are more payday loan storefronts than there are McDonald’s restaurants in the United States.
Although the CFPB remains confident that its proposed rule would better protect consumers, the ultimate effect that it would have on the lending industry and vulnerable borrowers remains unclear.
The CFPB invites the public to comment on its proposed rule until September 14, 2016.