Payday loans serve as a last resort for people with poor borrowing history and little savings, carrying punitive interest rates of 300% or more on an annual basis — an order of magnitude higher than the costliest credit card. And predictably, more than three quarters of the borrowers fail to pay back their payday loans when they're due (usually within 30 days), resulting in hefty penalties that force many borrowers to take out loan after loan as their debt mounts. That's why 14 states have ruled this form of non-bank lending to be inherently abusive and have effectively outlawed it.
Nevertheless, payday lending outlets are ubiquitous in the states where they remain legal; by one count, they outnumber the McDonald's franchises there. An estimated 12 million people take out payday loans every year, with about $24 billion borrowed in 2015. Alarmingly, the bulk of that volume is in repeat loans to people who borrow multiple times in quick succession. The industry may 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 don't earn enough to make ends meet.
On Thursday, a key federal regulator proposed new rules designed to wall off the debt trap posed by payday and other short-term loans. The long-awaited proposal by the Consumer Financial Protection Bureau could reduce the volume of payday loans by more than half, the bureau estimates, while shrinking the number of borrowers by only 7% to 11%. That's because the rules aim mainly at curbing serial borrowing, leaving payday loans as an option for those who need only a short-term boost to cover a one-time expense — in other words, the clientele that the industry says it's trying to serve.
Policymakers have known for years about the threat payday loans pose to desperate borrowers, yet federal bank regulators did nothing because payday lenders are outside their jurisdiction. That left states to set the rules, resulting in a crazy quilt of requirements and limits that were easy for lenders to evade though online or foreign-based operations.
The CFPB, which Congress created as part of the 2010 Dodd-Frank Act, does have jurisdiction over payday lenders, and the rules it has proposed would apply regardless of where the lenders were located. Those 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 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 they dip into directly to withdraw the full amount of the loan and their fees when they're due. Under the proposal, lenders would have to consider the borrower's complete financial picture, including other debts and living expenses.
You would think that lenders would do this sort of "underwriting" anyway, but payday lenders don't because they can extract payment from the borrower's account ahead of other creditors. And if the borrower's checking account doesn't have enough to cover the debt, lenders typically roll over the principle into a new loan and tack on more fees. 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 a borrower per year without checking the ability to repay. But that option is designed to make sure credit remains widely available. And to guard against these loans becoming debt traps, the rules would bar them from being rolled over into new loans unless the borrower pays off at least a third of the amount owed, with no more than three consecutive loans permitted. 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't be repaid on time.
The main complaint by payday lenders is that the proposal would "create financial havoc in communities" by eliminating a huge amount of short-term lending. But as states that have banned payday lending have found, more affordable alternatives emerge when payday lending storefronts disappear. The bureau's proposal also seeks to clear the way for longer-term loans with less egregious interest rates that are a better fit for people who can't afford to pay back an entire loan within 45 days. That's an area that state and federal policymakers should be focusing on too, so that better, safer alternatives emerge for the millions of people who've been payday loan customers simply because they have no other choice.