The Consumer Finance Protection Board has issued proposed rules governing payday and other small loans. Here is the overview and resources of what you need to know:
Payday lending is a form of loan in which an employed person takes an advance against their short term earnings. Such a loan is usually up to the next payday (2 weeks) and by definition taken while waiting for payday. The lending process involves a large fixed fee as well as an interest rate. The loan is expected to be repaid through the borrower’s next paycheck so a non-exhaustive underwriting is conducted in just a few minutes for repayment ability. The underlying notion being that IF the borrower can’t repay the lender will simply push the loan to another 2 weeks and collect a rollover fee. According to the CFPB, some ways that payday lenders give the borrower the money is to provide cash or a check, load funds onto a prepaid debit card, or electronically deposit the money into a checking account. The cost of the loan (finance charge) may range from $10 to $30 for every $100 borrowed. A typical two-week payday loan with a $15 per $100 fee equates to an APR (annual percentage rate) of almost 400%. Sequences of 8-10 rollovers are not uncommon.
Because of the high cost and interest rate, a typical consumer is unable to pay back within 2 weeks and ends up going back to the lender for an extension. Which is at the same finance charge and interest rate as the original loan. Each rollover buys 2 more weeks for pay back.
While announcing the proposed rules, CFPB Director Richard Cordray said the Bureau is motivated to end “the debt trap that plague millions of consumers across the country.” The debt trap he refers to are the rollovers (sequences) by borrowers who are consistently unable to repay the loans within their original terms – a $250 loan becomes $1000 because borrowers keep restructuring a prior, unpaid loan into a new loan with similar or more expensive terms.
According to CFPB’s research, 90% of the industry’s fees came from consumers who borrow seven or more times.
Latest data shows that payday lenders have loaned to as many as 12 million people annually, many of whom make less than $30,000 a year (or $15 per hour), resulting in a $38.5 billion industry with up to $8 Billion in annual fees. Combined with the $30 Billion overdraft industry and the $20 Billion late fee penalty industry the typical low income worker is living on the edge of fiscal despair. Given this situation, it is no surprise that only 37% of adults in the U.S. have the necessary savings to cover a $500 car repair or a $1000 emergency room bill. The remaining 63% are living under severe daily financial stress, waiting for payday and ever so often digging a bigger hole for themselves. Many of them work multiple jobs and their wages are not always fixed or predictable. A significant number of these borrowers also do not have access to credit or cash liquidity.
The CFPB’s proposed rules state that lenders would have to comply with either “Prevention Requirements” or “Protection Requirements” but not both.
The Prevention Requirements includes provisions that require lenders, at the outset, to make a good faith determination of the borrowers’ ability to repay the loan when due including interest, principal and fees for add on products without defaulting or re-borrowing. The determination would include evaluating their credit and borrowing histories, income, and major financial obligations. Financial history would include an analysis of housing, car, and child support payments. The rules also restrict the number of short-term loans borrowers can take in succession, often referred to as rollovers. The benefit of whether a borrower lacks the ability to repay is given in the borrower’s favor. If a borrower is found to be unable to repay three sequenced loans, they cannot be given a fourth loan until after the mandatory cooling off period.
The Protection Requirements alternatively allow lenders to extend loans if certain screening requirements are met which in turn protect against debt traps throughout the lending process. The lender would be constrained to limits covering the loan amount, repayment time, and finance charges. Consumers could not have other outstanding covered loans with any lender and similarly to the prevention requirements, rollovers would be regulated. The Protection Requirements are focused on ensuring an affordable way out of debt.
Finally, the CFPB proposals also apply to longer-term loans and the Bureau also restricts what it terms as harmful payment collection practices. These would require borrower’s notification before accessing bank accounts and limit unsuccessful withdrawal attempts that lead to excessive bank account fees.
THE TAKEAWAY: The primary motivation behind the CFPB’s rules appears to be ending payday debt traps. Since the CFPB has issued its proposed rules, analysts have both praised and criticized the CFPB. Those in favor of the proposed rules point out its aim to curb the debt trap created with rollover loans and the need to conduct greater due diligence regarding a borrower’s ability to repay a loan. Critics, on the other hand, do not feel the rules go far enough to limit the amount of installment payments and believe there continues to be a need to extend the repayment time.
Banks and credit unions are lamenting the lack of clear direction for their industry to craft financial products to what is obviously a significant portion of our working population’s need for immediate cash liquidity. Yet, none of the proffered solutions that are being discussed in light of the proposed rules are sustainable in their framework or ability to scale. What we are facing is a situation where 85% of the borrowers will no longer qualify to get access to small dollar amounts. No doubt, research and time is needed to sort out issues regarding the applicability, jurisdiction, and regulations governing the small dollar loan industry. But the urgency is real and palpable. This is not a climate change debate where the time scales are in decades. This is about helping 90M people deal with financial stress with the peace of mind to be peaceful citizens.
THE EMPLOYER IS THE MISSING LINK
Our next segment will discuss how businesses (employers) are the most natural solution to the problem. It is after all, waiting for payday and misaligned timing, that leads to payday loans and their predatory debt spiral. Wouldn’t it be prudent to put timing of pay as a variable in the mix? We have debated level of pay and structure of pay but avoided timing of pay. The cost is too high. It is time to do some uberizing and make a transformative impact on the lives of millions of workers. Disrupting timing of pay conforms to both the Protection and Prevention Requirements set forth by the CFPB, does not require lengthy and costly regulatory prerequisites governing banks and credit unions, and because benefits are offered through employment, lowered financial stress results in higher organizational productivity.
When you own or manage a business, your financial focus is likely on the bottom...