What the Crackdown on Payday Loans Will Mean to You

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After years of study and many reports, the Consumer Financial Protection Bureau this week proposed sweeping changes to the payday lending industry. The bureau has three basic concerns:
  • It believes that payday lenders do not underwrite borrowers before extending credit. These loans typically come with no credit checks, no verification of income and no analysis of their cash flow. In fact, payday lenders are acutely aware that if such an assessment were completed, most borrowers would fail because they cannot afford the loan.
  • The products are structured to be a debt trap. Most payday loans do not amortize. Instead, you pay a fee, which is typically $15 to $20 for every $100 you borrow for two weeks. At the end of two week, you have a choice. You can either repay the whole amount, in the form of a balloon payment, or you can extend by paying the fee. Given that product structure, most people extend. According to the bureau, 50 percent of borrower choose to extend the loan, and nearly 20 percent of borrowers end up extending more than seven times. By doing this, they get stuck in a very expensive debt trap.
  • Payday lenders are incredibly aggressive collectors. But the image of collectors with baseball bats is outdated. Instead, payday lenders are extremely aggressive with payment technology. As many as five times a day, they are debiting customers accounts, trying to find every dollar possible. Not only does this make it difficult for borrowers to manage their limited cash flow, but it also exposes them to overdraft and insufficient funds fees. At large banks, every incident can result in a $35 fee. So, if a payday lender tries to take a payment a few times in a day, it could result in over $100 of fees at the bank.
Underwrite or Cap Your Rate

The CFPB is giving lenders a choice. They can focus on prevention or protection. If a payday lender is willing to do a full underwriting of its borrower, which means a verification of income and a cash flow analysis, then no other major changes are required. This is a bit of a false choice. The CFPB knows quite well that most borrowers would fail a true affordability test.

The second option effectively amounts to a rate cap. For short-term loans (of less than 45 days), the CFPB would not allow lenders to make more than three consecutive loans. In other words, this limits the number of rollovers. It would also require that the principal balance goes down over time, rather than up. By forcing loans to become amortizing and payable, they are effectively driving down the price of the loans.

For longer-term loans (greater than 45 days), the CFPB is proposing an explicit rate cap of 28 percent. But it is weighing that against a limit on the monthly payment so that it is not more than 5 percent of the borrowers' monthly income.

But Will It Work?

Payday lenders have such high margins because short-term payday loans today are effectively interest-only loans that never get paid off. Longer term title loans have interest rates well above 28 percent. The CFPB is giving the lenders a choice: you can either underwrite the borrowers, or cut your costs.

The CFPB has proposed actions to limit the abuse of the payment system. It wants any lender to give notice to customers three days before money is deducted from their account. This will help borrowers avoid the surprise. But the bigger change requires that if a lender makes two unsuccessful attempts at taking a payment, they can not make a third attempt unless the borrower gives permission. This is a massive change.

Payday lenders are very good at working through the loopholes of laws. As these guidelines are transformed into rules, there will be thousands of lawyers figuring out ways around them.

Lenders have a choice here. And the most ambiguous part of that choice is around affordability. For years, lenders have been able to document proof of affordability when it doesn't exist. That is my biggest fear with the proposed rule.

The payday industry is long overdue for change. The need for short-term borrowing will always be there. But we can't have an industry that has designed products whose sole purpose is to trap people in debt, rather than to make a decent return and provide a service.

What Can I Do?

If you have debt that you cannot afford to pay off, you need to take time to build a plan to get debt free, rather than going from payday loan to payday loan. A good starting point would be the MagnifyMoney Debt Guide, which helps you make a plan to become debt free. That plan could range from seeking out a nonprofit consumer credit counselor to consolidating your debt into an amortizing personal loan. But just continuing to return to the payday lender, or continuing to pay the minimum due on a credit card, ensures that you will never get out of debt.

Nick Clements is the co-founder of MagnifyMoney.com, a price comparison website that helps you find the cheapest bank accounts, and the best interest rates on your savings and your debt. He spent nearly 15 years in consumer banking, and most recently he ran the largest credit card business in the U.K. You can follow him on Twitter @npclements
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