Each year, roughly 12 million Americans face sufficient financial hardship that they turn to a costly and potentially hazardous alternative: short-term, high-interest consumer loans, colloquially referred to as “payday loans.” These products offer the lure of immediate relief but at an exorbitant cost, too often leading to a downward spiral of re-borrowing (at additional cost).
In 2017, the Consumer Financial Protection Bureau adopted tighter standards on payday lenders, specifically requiring them to make a rudimentary effort to verify the borrowers’ ability to repay. The rules are slated to take effect in August.
But new management at the CFPB has reversed course. Under new leadership, the bureau has proposed rescinding the underwriting rules and returning to status quo ante. The proposal is entering a mandatory 90-day comment period before final adoption. The ultimate effect will likely be to ensnare more financially distressed Americans in a hopeless debt trap.
The CFPB was established in 2010 as part of the Dodd-Frank financial reform legislation, passed in response to the financial crisis a decade ago. The agency suffered from some fundamental design flaws and was ensnared in partisan politics from the outset. Yet it has served a valuable purpose in consolidating disparate consumer protection functions of the federal government and has produced some beneficial results. One of these is expanded protection from predatory lending.
A typical transaction involves a two-week loan of $375. According to research from the Pew Charitable Trusts, the average borrower remains in debt for five months of the year and incurs a total of $520 in fees on the original loan of $375. That translates into an astronomical annual percentage rate of 391 percent (a quick check on two local lenders’ websites shows a 460 percent APR) and a total of $9 billion in loan fees each year.
Although these high-cost loans are purported to target unanticipated one-time emergencies, in fact, the lion’s share are to repeat borrowers: seven in 10 borrowers use the cash to meet ongoing expenses like rent and utilities, and the average borrower is in debt to payday lenders for five months of the year. The CFPB reports that 80 percent of payday loans are initiated within two weeks of a previous loan, and 75 percent of loans are to people who take out 11 or more per year. For these reasons, 18 states have effectively outlawed payday lending directly or through fee caps, but 32 states still permit them.
The new rules from CFPB on that type of loan were a small step in the right direction. They required payday lenders to apply the same criteria by which conventional lenders underwrite: verification of employment, pulling a credit report, and estimating ongoing monthly obligations to show the borrower’s ability to repay. The regulation also prohibits lenders from attempting to directly charge a borrower’s bank account after two unsuccessful attempts (a common practice which resulted in mounting charges for insufficient funds and deepens the hole). The latter rule will continue in force for now.
These provisions are hardly unreasonable, yet the payday lending industry mounted a successful effort to convince the new Bureau director that these strictures represented an unreasonable burden.
That a consumer protection agency would undo a reasonable and obviously needed safeguard may seem strange at first. But note that the recently appointed director is a protégée of the former interim director, who once called the agency a joke and whose stated mission at the helm was to vitiate the bureau.
The CFPB rules were straightforward and would have prevented thousands of Americans from spiraling into a perilous debt trap. Caveat emptor.
Christopher A. Hopkins, CFA
Vice President and portfolio manager
Barnett & Company