The Consumer Financial Protection Bureau has finally turned its regulatory gaze to short-term lenders — think payday loan and automobile title loan companies — that build businesses around loans that can't be repaid. The bureau floated a potential rule last week that addresses the central problem with such loans: borrowers being swamped with penalties and fees for loans they should never have been granted.
At the insistence of regulators, banks won't dole out loans or credit cards to customers who can't meet their borrowing standards. That practice has fueled the $46-billion market for payday loans, which just about anyone with income and a bank account can obtain from a non-bank lender, and similar products such as auto title loans, which use a person's car or truck as collateral. Proponents say these loans help people with lousy credit pay unexpected bills. But the bureau's research shows that a payday loan can quickly become a problem, not a solution: More than 80% of them were followed within two weeks by another one, and more than half went to borrowers who took out 10 or more in quick succession.
Critics point to this repetitive borrowing as proof that much of the industry's profit comes from people trapped in debt. The patchwork of state regulations on non-bank lenders, however, leaves some states with no protection and others with little ability to enforce their safeguards effectively. That's why the Consumer Financial Protection Bureau is considering national rules that would give lenders a choice: either verify a potential customer's ability to repay before issuing a loan, or abide by strict limits on the terms and frequency of their loans.
Some consumer advocates argue that lenders should have to verify every customer's ability to repay. To do otherwise, they say, leaves room for loans to desperate customers who will get caught in a vicious cycle of penalties and additional borrowing. But there's evidence that the right limits can protect against such debt traps. For example, when Washington barred borrowers from taking out more than eight payday loans per year, the number of loans and the amount of fees collected dropped about 75%. By contrast, California has a law against issuing multiple payday loans to individuals, but it's toothless because lenders aren't required to report who gets a loan.
Although the bureau hasn't made a formal proposal yet, it has a promising outline for rules that could stop lenders from taking advantage of borrowers without cutting off those who have bad credit scores but have a real ability to repay. The key, as California unfortunately has shown, is making sure not just that the limits are sensible, but that they can actually be enforced.