Payday loans serve as a last resort for people with poor borrowing history and low savings, with punitive interest rates of 300% or more on an annual basis – an order of magnitude higher than the most expensive credit card . And predictably, many borrowers do not repay their payday loans when they are due (usually within 30 days), resulting in strong penalties that force many borrowers to take loans after loans as their debt mounts. That is why 14 states have ruled that this form of non-bank lending is inherently abusive and has effectively proscribed it.
However, payday loan branches are ubiquitous in states where they remain legal; For a charge, they outnumber McDonald’s franchises there. It is estimated that 12 million people take payday loans every year, with about $ 24 billion borrowed in 2015. Alarmingly, most of that volume is in repeat loans to people who loan several times in quick succession. The industry can characterize payday loans as short term financing for people with unexpected bills to pay but the data suggest that they have become an expensive crutch for those who do not earn enough to make ends meet.
On Thursday, a major federal regulator proposed new rules designed to eliminate the debt trap represented by payday loans and other short-term loans. The long-awaited proposal by the Office of Consumer Financial Protection could reduce the volume of payday loans by more than half, the office estimates, while reducing the number of borrowers by only 7% to 11%. This is because the rules primarily aim to curb the serial lending, leaving the payday loans as an option for those who only need a short-term boost to cover a single expense.
Politicians have known for years about the threat of payday loans pose to desperate borrowers, however federal bank regulators did nothing because payday lenders are out of their jurisdiction. That left the states to set the rules, resulting in a crazy quilt of requirements and limits that were easy for lenders to evade through online or foreign operations.
The CFPB, which Congress created as part of the 2010 Dodd-Frank Act, has jurisdiction over payday lenders, and the rules it has proposed will apply regardless of where the lenders are located. These rules would extend to short-term loans an important principle that Dodd-Frank applied to mortgages: with one notable exception, lenders have to make sure that a borrower can repay them before issuing the loan. Today, payday lenders simply verify that an applicant has a paycheck and a checking account, which are submerged directly in withdrawing the full amount of the loan and their fees when they are due. Under the proposal, lenders would have to consider the borrower’s full financial picture, including other debts and living expenses.
You might think that lenders would do this type of “underwriting” anyway, but payday lenders do not because they can extract payment from the borrower’s account ahead of other creditors. And if the borrower’s checking account does not have enough to cover the debt, lenders often pass the principle on a new loan and tactic at more rates. Such rollovers are common; More than half of payday loans are issued in sequences of 10 or more consecutive loans.
Some consumer advocates complain that the exception in the proposed rules would allow payday lenders to make up to six loans to one borrower per year without checking repayment capacity. But that option is designed to ensure that credit remains widely available. And to guard against these loans becoming debt traps, the rules would prevent them from being rolled over into new loans unless the borrower pays at least a third of the amount owed, with no more than three consecutive loans allowed. This restriction could expose payday lenders to more defaults, but that would have the welcome effect of encouraging them not to make loans that can not be repaid on time.
The main complaint of payday lenders is that the proposal “would create financial havoc in communities” by eliminating a huge amount of short-term loans. But as states that have banned payday loans have found, more affordable alternatives arise when payday loan stores disappear. The proposal of the office also seeks to clear the way for longer-term loans with less heinous interest rates which are a better fit for people who can not afford to pay off an entire loan within 45 days. That’s one area that state and federal politicians should focus on too, so better safer alternatives emerge for the millions of people who have been customers of payday loans simply because they have no choice.