Efforts to rein in the worst abuses of payday lending are on the right track and long overdue. If it does the job well, the Consumer Financial Protection Bureau will end an abusive scheme that has dragged countless lower-income Americans into bankruptcy, destroyed their credit and trapped them in financial quicksand.
There is nothing radical or extraordinary about the proposal the CFPB has begun to outline. At its heart, the new rules the bureau has in mind would simply require payday lenders to do what responsible lenders — including some credit unions and mortgage companies — do as a matter of course. It will require creditors to make affordable loans.
An affordable loan is one that the borrowers can reasonably be expected to pay off in-full and on-time without re-borrowing or defaulting on other important bills such as rent or utilities. A lender determines whether a loan is in fact an affordable loan by assessing the borrower’s income and weighing it against the borrower’s expenses.
The truth is that the payday lending industry’s business model is to make bad loans. In fact, the industry makes three-quarters of its fees from borrowers with more than 10 loans in a year. Here’s how it works: Payday lenders make their money from the fees paid on the loan — fees that work out to an unbelievable average of nearly 400 percent in annualized interest. Because a fee is paid each time a loan is made, the lender actually has a vested interest in not having the loan paid back the first time — or the 10th.
For the lender, the key is getting the borrower into an initial unaffordable loan, allowing the lender to trap the borrower in many successive loans. A borrower with a $500 initial loan can either repay the loan plus fees, averaging $575 total, two weeks later or just pay the $75 fee to effectively extend the loan another two weeks.
If you didn’t have $500 last week, you are unlikely to have $575 two weeks later. So most borrowers are forced to pay only the fee and be flipped from one loan into another, continually, in this fashion. That’s the debt trap. Worse, the lender is in the driver’s seat as they are set up to take the money owed them on the original loan, plus the fees and interest, directly out of the borrower’s bank account.
Most borrowers have an average of nine payday transactions a year, and the price tag just keeps growing. The typical payday borrower will wind up paying $450 in fees to take out a $350 loan. One-third of the time, when borrowers do pay off these loans, they overdraw their checking accounts, incurring yet more fees.
It’s hard to imagine a scenario in which this helps anyone deal with a financial emergency. In fact, the reality is that payday lending creates financial emergencies.
We are a nation of innovators, and already many lower-cost solutions to small-dollar credit exist. If we truly want to solve the problem of access to credit to help lower-income Americans deal with emergencies or unanticipated expenses, the first step is to stop the debt trap so that responsible businesses have more opportunity to make inroads in the market.
It’s time we give them a chance.