The Consumer Financial Protection Bureau proposed new rules on Thursday designed to end what it calls "payday debt traps" by requiring lenders to make sure a borrower can repay that loan before approving it.
The new rules would cover a variety of small-dollar loans marketed to financially vulnerable consumers, such as payday loans, auto title loans (where the vehicle is used as collateral), high-cost installment and open-ended loans.
CFPB director Richard Cordray acknowledged that people who live from paycheck to paycheck may need a loan to cover unexpected expenses or a drop in income, but he said the credit products marketed to these consumers should help them, not hurt them.
"Too many borrowers seeking a short-term cash fix are saddled with loans they cannot afford and sink into long-term debt," Cordray said in a statement. "It's much like getting into a taxi just to ride across town and finding yourself stuck in a ruinously expensive cross-country journey. By putting in place mainstream, common-sense lending standards, our proposal would prevent lenders from succeeding by setting up borrowers to fail."
The CFPB's long-awaited rulemaking comes after years of studying the marketplace for credit. As expected, the lenders that would be affected by the rules don't like them. And some consumer groups aren't entirely happy — they don't think the CFPB went far enough.
What the CFPB is proposing
The CFPB wants lenders to determine upfront that a customer can afford to repay their loan without re-borrowing. The agency's data shows that:
- Most people who take out a short-term payday or auto title loan roll them over when they come due or end up borrowing again within a short period of time. This turns that short-term loan into a costly long-term loan.
- One-in-five payday loan sequences end in default and one-in-five single-payment auto title loan borrowers have their vehicle seized by the lender for failure to repay.
The proposed "full-payment test" would require lenders to determine whether the borrower can afford the full amount of each payment when it's due and still meet basic living expenses and major financial obligations.
What does full payment mean?
- For payday and auto title installment loans without a balloon payment, a person must be able to afford all of the payments when due.
- For short-term loans and installment loans with a balloon payment, they have to be able to afford the total loan, fees and finance charges without having to re-borrow within the next thirty days.
The new rules would make it difficult for lenders to push distressed borrowers into refinancing the same debt, and also cap the number of short-term loans that can be made in quick succession.
The proposal would allow lenders to offer some small-dollar loans with more flexible underwriting standards, if strict requirements are met.
For example, there's the "principal payoff option" on short-term loans of up to $500. The lender could offer certain borrowers up to two extensions on that loan, but only if the borrower pays off at least one-third of the principal with each extension.
The CFPB also wants to prevent lenders from making repeated attempts to collect payment when the customer's checking account has insufficient funds. This practice can result in a series of costly penalty fees.
Under the proposal, lenders would be required to give their customers written notice before attempting to debit their account for any loan covered by the rules. After two straight unsuccessful attempts, the lender would be prohibited from debiting the account again unless it gets a new and specific authorization from the borrower.
Reaction: Pro and con
Dennis Shaul, CEO of the Community Financial Services Association of America, the trade group that represents payday lenders, said the proposed protections will hurt consumers and result in thousands of small lenders being forced out of business.
"The CFPB's proposed rule presents a staggering blow to consumers as it will cut off access to credit for millions of Americans who use small-dollar loans to manage a budget shortfall or unexpected expense," Shaul said in a statement.
The CFSA also criticized the rules for not addressing the problem of illegal and unlicensed payday lenders.
The American Financial Services Association, the national association for the consumer credit industry (including traditional installment lenders) also expressed disappointment. In a news release, AFSA said the CFPB proposal did not go far enough and would "harm consumers' access to safe, responsible credit."
Consumer advocacy groups also had some criticisms.
The National Consumer Law Center called the CFPB proposal "a strong start," but said the rules need to be stronger.
"The CFPB has proposed the common-sense rule that lenders should only make loans that borrowers have the ability to repay without re-borrowing," said NCLC associate director Lauren Saunders. "However, the proposal has worrisome loopholes."
Nick Bourke, director of the Small-Dollar Loans Project at The Pew Charitable Trusts, said the ability to repay requirement does not make these loans safe.
"Payday loans are harmful, and reform is urgently needed, but the CFPB's proposal misses the mark," Bourke told NBC News. "Installment loans at 400 percent APR are still harmful even with more underwriting. Strong CFPB rules are badly needed, but this proposal focuses on the process of originating loans rather than making sure those loans are safe and cost less."
Pew would like to see the CFPB limit loan payments to five percent of the borrower's paycheck and set a "reasonable time period" for the term of that loan of no more than six months. The Pew Charitable Trusts has done several in-depth studies of the payday loan market. Here are some key findings from this research:
- Approximately 12-million Americans use payday loans each year. They spend an average of $520 in fees to repeatedly borrow $375 in credit.
- Payday loans are sold as two-week products for unexpected expenses, but seven in 10 borrowers use them for regular bills. The average borrower ends up in debt for half the year.
- Payday loans take up 36 percent of an average borrower's next paycheck, but most borrowers cannot afford more than five percent. This explains why most people have to re-borrow the loans in order to cover basic expenses.
What do you think? The CFBP will be taking public comments on its proposed rules until Sept. 14, 2016.