Analysis

How CFPB Rules Can Encourage Banks and Credit Unions to Offer Lower-Cost Small Loans

Payday loan reform: An evaluation, Part 3

Most people who use payday and similar loans live paycheck to paycheck, have damaged credit profiles, and frequently have trouble paying their monthly bills. They also tend to have volatile income that fluctuates by more than 25 percent from month to month (think of those who earn hourly wages at jobs with unpredictable schedules). This helps explain why 7 in 10 borrowers say they use payday loans mainly for recurring expenses such as rent, mortgage, and utilities. Borrowing cannot solve fundamental problems, including low wages or poor financial planning, but affordable, fairly structured small installment loans can help bridge gaps in the budgets of these vulnerable consumers. Banks and credit unions could play a large role in ensuring access to such safe small credit, but only if regulators provide guidelines that are clear and simple.

Thanks to the Consumer Financial Protection Bureau (CFPB), conventional payday loans are on the decline. In response, lenders have begun to shift toward offering longer-term installment payday loans, which are safer but often also needlessly expensive. Because the bureau cannot regulate interest rates or eliminate all high-cost small loans, these new products will probably remain widely available even after the CFPB completes its regulations.  What is unclear is whether traditional financial institutions will enter this market and offer better types of small installment credit options under the CFPB rules. Currently, banks generally do not provide small loans to financially fragile customers (with the unfortunate multibillion-dollar exception of fee-based overdraft), and only 1 in 7 federal credit unions offers a payday alternative loan: In 2014, such institutions made only 170,000 such loans, compared with more than 100 million payday loans.

If new and better forms of small credit are to emerge from banks and credit unions, it is up to federal regulators to break the logjam, starting with the CFPB. Many traditional financial institutions, including some very large ones, have expressed interest in serving this market, but only if they can confidently operate within clear regulatory guidelines. Decisiveness and clarity from the CFPB and other regulators are essential. Firm rules about acceptable loan structures, underwriting, and pricing would ensure that new products are safe for borrowers (unlike deposit advance loans, for instance, which were simply lump-sum payday loans offered by a handful of banks until regulators stopped the practice in 2013). Clear rules for a new type of small installment loan would help banks and credit unions avoid regulatory violations and automate the loan origination process, which would keep prices down.

Encouraging banks and credit unions to offer small credit options makes sense because they are federally regulated entities that can make such loans at prices that are at least six times lower than payday loans, which will probably continue to exist in the years ahead. Traditional financial institutions have significant competitive advantages over payday lenders, including large existing branch networks, diversified product lines, existing relationships with borrowers, and the lowest cost of funds in the industry. By contrast, nonbank lenders incur substantial costs that they must cover from revenue on a narrow line of products. Storefront payday lenders spend two-thirds of their revenue on overhead, and customer acquisition and defaults are major cost drivers for online lenders.

Payday loan borrowers are worthy candidates for loans from traditional financial institutions because they are already bank or credit union customers. (To get payday loans, consumers must have checking accounts.) Yet millions of them go outside their financial institutions to access small amounts of credit, spending roughly $9 billion on payday loans and $3 billion on auto title loans each year. The availability of lower-cost credit from traditional financial institutions could save these consumers more than $10 billion annually, help them to improve their credit scores, and give them access to safer, more affordable products. These loans would also provide an alternative to costly overdrafts: Unlike a $35 fee for an overdraft, a $35 fee for a $300 installment loan looks like a fair deal to most Americans.

The CFPB is not the only regulator in the small loan market, but it is the most important, and it must act boldly to set clear federal standards. If the CFPB leads the way, other federal agencies that regulate the safety and soundness of financial institutions (known as “prudential” regulators) can also help by permitting banks and credit unions to issue responsible, lower-cost small installment loans according to the CFPB’s guidelines. These agencies include the Office of the Comptroller of the Currency (OCC), Federal Reserve Board of Governors, Federal Deposit Insurance Corp. (FDIC), and National Credit Union Administration (NCUA).

Two main factors will determine whether the CFPB’s final rules make lower-cost bank and credit union lending feasible. The rules should include: 

  1. A clear regulation that traditional financial institutions could rely on when structuring new and better types of small-loan programs. For example, the CFPB’s March 2015 proposed framework included a “longer-term alternative” option that, if enacted, would require loans to have affordable monthly payments of no more than 5 percent of customers’ monthly income and reasonable durations of no more than six months. In a national survey, 76 percent of Americans said a loan made under this framework would be fair, compared with only 17 percent who said a commonly available payday loan is fair. Respondents also considered this type of alternative bank loan to be much more fair than typical checking account overdraft fees. The CFPB should finalize that option, or something very similar, in its published rules.
  2. Specific guidance from prudential banking regulators (the OCC, FDIC, Federal Reserve Board, and NCUA) to allow for fast and low-cost origination of safe small-dollar loans in compliance with the CFPB’s rule at prices that are fair to borrowers and lenders. (See table below.)

Under these conditions, Pew estimates that banks and credit unions could sustainably offer alternative loans to millions of their customers who use payday loans, potentially saving borrowers billions of dollars a year.

Banks and Credit Unions Could Offer Affordable Small-Installment Loans, Given Proper Regulatory Guidance

Estimate of viable credit products with payments of no more than 5% of borrower income

$500 loan $400 loan $300 loan
Loan term 5 months 4 months 3 months
Monthly payment $120 $116 $112
Total cost $100 $64 $36
Average cost of this credit
using payday loans today
$750 $480 $270

Source: “Understanding the CFPB Proposal for Payday and Other Small Loans,” The Pew Charitable Trusts (July 2015), http://www.pewtrusts.org/~/media/assets/2015/07/cfpb-primer_artfinal.pdf

© 2016 The Pew Charitable Trusts

Nick Bourke directs the small-dollar loans project at The Pew Charitable Trusts.

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