Alternative Finances

The CFPB, Payday Lending And Unintended Consequences

The CFPB has begun to take the first steps toward more intensive legislation of the short term, small dollar borrowing space – also known as payday lending.

Last week, the Federal consumer watchdog announced that it is considering a proposal that would require lenders to take additional steps to ensure consumers have the ability to repay these loans. The proposed rule would also restrict payment collection methods that apply fees “in the excess.”

“Today we are taking an important step toward ending the debt traps that plague millions of consumers across the country,” CFPB Director Richard Cordray remarked at a Field Hearing on Payday Lending in Richmond, Virginia. “Too many short-term and longer-term loans are made based on a lender’s ability to collect and not on a borrower’s ability to repay. The proposals we are considering would require lenders to take steps to make sure consumers can pay back their loans. These common sense protections are aimed at ensuring that consumers have access to credit that helps, not harms them.”

The announcement has caused a bit of a stir in the days since – though much of the reaction has been positive. The New York Times’ editorial board ran with the headline: “Progress on Payday Lending” to lead off their thoughts on the subject, while The Washington Post went with the slightly less laudatory (but still pretty encouraging) “Payday lending is ripe for rules.”

“If you lend out money, you have to first make sure that the borrower can afford to pay it back,” President Barack Obama told students last Thursday while speaking on behalf of the law. “We don’t mind seeing folks make a profit. But if you’re making that profit by trapping hard-working Americans into a vicious cycle of debt, then you got to find a new business model, you need to find a new way of doing business.”

And indeed it is really hard to rally behind anything called a debt trap – and it is hard to imagine anyone being a strong supporter of seeing hard-working Americans trapped in a vicious cycle of debt.

That said, a holy war on short-term lenders might not be the solution that is actually warranted because it seems possible that the nature of payday lending is not all that well understood, even by highly educated watchers.

For example, in The New York Times’ initial report on the proposed rule change, the paper of record defined payday lending as a $46 billion industry that “serves the working poor.”

While not an uncommon way to view short-term lending, it might just be a little misleading.

A study by the Division of Research of the Federal Reserve System and Financial Services Research Program at The GWU School of Business found that 80 percent of people who take out short-term loans make more than $25K per year, while 39 percent make more than $40K. Only 18 percent of payday borrowers make less than $25K a year – which is generally what most people picture when they picture the working poor. A salary of $25K- $35K is what most social workers and early career teachers earn – two groups of people that we can all agree are underpaid, but are generally not considered to be “the working poor.”

Moreover, a Pew Charitable Trust survey – one that tends to be popular among opponents of short term, small dollar lending because it reports that most “two-week payday loans” are actually paid out over the course of five months, also indicates that income level is not, in fact, the most predictive criteria for whether or not a consumer will use a short-term loan. High income house-renters are far more likely to take out a short-term, small dollar, loan than low-income homeowners; people with some college are more likely to borrow than people with no college or with a college degree; and young people (under the age of 30) overwhelmingly use the service more than their older counterparts – regardless of their income.

So, it’s easy to reduce the problems with payday lending to protecting the poor against the wicked vicissitudes of predatory lenders – but that reduction, like many in this space is not exactly borne out by the facts on the ground.

We at PYMNTS would like to help to sort out the issue beyond the sound bites – so we’ll explain what the changes are, why newspaper editorial boards like them so much and why there might just be room for concern.

What Are The Proposed New Payday Lending Rules?

The new protections would apply to all forms of short-term loan products and longer-term credit products that are said to target the most financially “vulnerable” consumers – such as high interest installment loans. If the rule change is made, the CFPB would require lenders to implement one of two options to make sure that borrowers do not end up in an unending cycle of debt.

The first option is called debt trap prevention, and would require lenders to determine, at the outset of a lending process, whether a consumer could repay the loan and all fees on time, without defaulting or re-borrowing.

The second option is debt trap protection, which would require lenders to offer affordable repayment options as well as limit the number of loans per borrower within specific time frames. For longer-term loans, debt trap protection would mean applying either an interest-rate (and application fee) cap, or limiting monthly dues to equal a maximum of 5 percent of the borrower’s gross monthly income.

As for collection practices, the CFPB is also considering proposals that would require borrower notifications before accessing deposit accounts and limit unsuccessful withdrawal attempts that lead to excessive deposit account fees.

Why So Popular?

As The Washington Post put it, “Basically, it mandates the kind of underwriting that payday lending characteristically avoids. This could go a long way toward ending, or at least reducing, payday-lending horror stories.”

And the horror stories are well known – a borrower goes in for a relatively small (couple of hundred dollar) loan, and through partial payments, falling behind, extending the loan and perhaps even taking out supplemental payday loans to pay the first – the borrower ends up paying thousands of dollars in fees after months and sometimes years, before defaulting entirely.

Proponents argue that this situation is not an anomaly, but is, in fact, baked into the system. A report on a study of 12 million payday loans issued all across the country released by the CFPB subsequent to their announcement of the proposed rule change, seems to back up that claim.

According to the report, one in five borrowers eventually defaulted on their short-term loan and nearly two-thirds ended up renewing it. According to the report, some of those borrowers renewed their loans up to 10 times, turning a “short-term” loan into something they were paying on for a long time. In three-fifths of the cases studied, the fees ended up exceeding the original amount of the loan.

The Times’ editorial board noted that this report “Debunked the industry’s claim that the loans were necessary to help people make it to the next payday — customarily two weeks away — at which point they could comfortably pay off what they owed.”

Unintended Consequences

It seems The Times got that half right – it is certainly the case that the CFPB report, especially in conjunction with the Pew report, demonstrates that many short-term loans are not “short” in the sense they only have a two-week duration, since a majority of consumers choose to extend.

However, it is not clear what relationship the CFPB report, or proposed rule-making, has to the first half of the the sentence “the loans were necessary to help people make it to the next payday.”

Research shows again and again, the majority of loans are used to cover recurring expenses – food, utilities, rent, mortgage, etc.

“Just need to get to the next paycheck. And I need, you know, either pay the bill to keep the lights on, or need some food, or whatever it is,” one Chicago-based payday borrower told Pew for their study.

“If I have bills to pay, or say I need food on the table, I am going,” said a San Francisco participant.

It seems that the first half of the sentence remains entirely true – consumers need these loans to get them to their next payday. They may not be able to pay them off at the time, but that doesn’t actually change the reality of the initial need.

Moreover, this leads to a question about harms – and where the most serious risks of harm obtain to consumers who regularly make use of short-term loans.

“If the CFPB is going to stop some unscrupulous payday lenders from tricking people into paying high interest rates to borrow money I’m all for it,” MPD Founder and Chairman Dr. David Evans noted. “But, what I’m afraid the CFPB is doing is making it tough for people who need to borrow money, for reasons they probably know, but the CFPB doesn’t, to get loans. Maybe they have an emergency where they can’t get a loan, and they’ll be screwed if they don’t have access to money. Or maybe they’ll go to loan sharks or other really shady lenders that aren’t visible to the CFPB and have their knee caps popped if they can’t pay it back. It doesn’t sound like the CFPB has thought through all the unintended consequences of its planned crackdown.”

Though the narrative tends to be about a “never-ending cycle of debt,” the data indicates otherwise – it is in most cases a several months long cycle of debt that 80 percent of the time results in the loan being paid off.

Which, given the business money lenders are in, shouldn’t be too surprising.

“All of the market is going after people who can’t pay them back? That’s ridiculous,” Nathan Groff, chief government relations officer for Florida-based Veritec Solutions LLC told MPD CEO Karen Webster in a recent conversation. “If they don’t get paid back or lose money, it’s not a success.”

It does seem an implausible assumption to make that an entire industry is built upon a business model that plans on consumers defaulting on the loans they are making.

Groff noted that being in the business of giving away money is easy. Being in the business of lending money and getting it back is not easy – which is why subprime borrowers pay so much for their money. At the end of the day, a short-term lender is like any other lender – they need to mitigate their risk.

“Every day we see people who are innovating in lending,” Groff observed. “They say, ‘we’re going to Facebook to use their data points, we’re going to fine-tune our risk metrics.’ And that’s great – but at some point, when you strip everything away, the fees have to get somewhat close to the risk the lenders are taking.”

And those fees are high, and on average rolled out across an entire year. The harm payday lenders face in this scenario is paying far more than an average borrower would – and that is a real harm especially for the 57 percent of borrowers who earn less than $35K a year.

However, that harm can be stacked against the harm of not paying a utility bill on time – which can result in lights being switched off and the possibility of expensive turn-on fees and deposits for continued use. Unpaid traffic tickets or unmade car repairs can both result in loss of transportation, which then risks continued employment. Generally speaking, not eating is a not a good idea – and most payday lendees don’t actually qualify for food stamps. And there are, as Dr. Evans pointed out, many lenders in the world who are happy to offer you a loan – but who resort to beatings instead of collection agencies when they are not paid.

Overpaying is a harm; starving, losing housing, losing power, losing a job or getting a debt beat out of one are worse harms and ones that are at least risked when one makes the business of short-term lending unpalatable for businesses, if not outright illegal.

There are no easy answers here.

“We gotta be careful. There are people who say there have never been a problem with the product, and there are also people saying anyone who takes [a payday loan] out is in a cycle of debt,” Groff told Webster.

And it’s surely the case that there are bad payday lenders who do need to be cleaned out. However, if any attempt to curtail the payday lending industry is hailed a “progress” merely because the industry is itself evil – well, that should be a concern. Taking away lenders will not take away the need for their loans, and a solution that doesn’t solve for that probably isn’t a real solution at all.

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