In October, the Consumer Financial Protection Bureau (CFPB) finalized a regulation for conventional payday loans and auto title loans of up to 45 days. Research by The Pew Charitable Trusts has shown that such loans harm consumers because paying them off costs a third of the typical borrower’s next paycheck, leaving borrowers unable to cover basic expenses without reborrowing, which leads to extended indebtedness and spiraling costs. The new rule lays a strong foundation that protects consumers and keeps the door open for banks and credit unions to offer lower-cost installment loans, but states and federal bank regulators will need to fill key gaps to provide a safe, affordable small-dollar loan market. Credit unions and banks are generally unaffected by the regulation except as regards certain uncommon very short-term loans.
The CFPB rule addresses the core problems with most payday and auto title loans up to 45 days by requiring lenders to assess applicants’ ability to repay or limiting payday loans to $500, restricting total indebtedness to 90 days within a given 12 months, and requiring subsequent loans to be smaller. However, it leaves other issues in the market unaddressed: It does not cover payday and auto title installment loans lasting longer than 45 days and does not establish guidelines to enable banks and credit unions to provide safer loan alternatives. Other state and federal policymakers will need to act to fill these gaps.
How the rule regulates short-term loans
The CFPB rule covers any loan with a term of 45 days or less, except for certain types of credit, such as overdraft, credit cards, and pawn. All lenders that issue covered loans will have two options for complying with the rule. The first requires the lender to make a “reasonable determination” of affordability by using a CFPB-defined ability to repay (ATR) process that includes assessing the income and major expenses, debt obligations, estimated living expenses, and borrowing history of each applicant. The CFPB refers to this as the “full-payment test” in its press materials. The rule also includes a provision in which three consecutive loans of this type will trigger a 30-day cooling-off period for that customer, during which no additional borrowing is permitted.
In practice, few loans are likely to be made under the ATR process because most borrowers cannot meet the affordability standard and because lenders may find the process too costly. Instead, lenders are likely to use the second compliance option, known as the “conditional exemption” or “principal-payoff,” which allows lenders to issue single-payment loans lasting 45 days or less without assessing the ATR under the following conditions:
- The loan is $500 or less.
- Any subsequent loan issued within 30 days is at least one-third smaller. For example, if the first loan is $450, the second may not exceed $300, and the third could be no more than $150.
- No more than three consecutive loans may be issued per borrower (a loan is considered consecutive if another was outstanding within the past 30 days).
- During the previous 12 months, the borrower has received fewer than six covered loans and has not been in debt for 90 days.
- Car titles may not be used as security.
Installment loans and lines of credit lasting longer than 45 days are not covered by these requirements, except in unusual cases where the loan requires a “balloon payment” that is more than twice as large as any other payment.
The rule also includes measures to limit penalty fees when lenders take access to a customer’s checking account to facilitate repayment and a narrow exemption for what the CFPB refers to as “less risky” options, such as occasional “accommodation loans” that some credit unions and community banks provide to customers on an ad hoc basis.
If properly enforced, the regulation will probably lead to a dramatic reduction in the number of harmful short-term payday and auto title loans because few borrowers are likely to qualify under the ATR rules, and lenders using the conditional exemption will be required to limit borrowers’ number of loans and days of indebtedness. Instead, payday and auto title lenders will probably continue to shift toward installment loans and lines of credit that last longer than 45 days. As a result, federal bank regulators and state policymakers will need to act to ensure that this emerging market is safe for consumers.
Federal regulators should allow banks and credit unions to offer safe small installment loans
Pew urges federal bank and credit union regulators to seize this opportunity to enable financial institutions to offer affordable small installment loans that will save financially vulnerable families billions of dollars a year. Our research shows that the public strongly supports this: The overwhelming majority of Americans, and payday loan borrowers in particular, want banks and credit unions to offer small installment loans. The Office of the Comptroller of the Currency (OCC) and other bank regulators should take steps to reduce the cost of small-dollar installment lending for these institutions, particularly by allowing them to automate the origination and underwriting of small loans that last longer than 45 days and meet safety criteria, including a clear definition of affordable payments and a simple cost structure that protects against hidden or front-loaded fees.
Pew also continues to encourage adoption of a definition of affordable payments that would shield 95 percent of a borrower’s paycheck from creditors by limiting payments to 5 percent of income. For example, a customer making $2,500 a month ($30,000 a year) would repay a loan in monthly installments of no more than $125. Borrowers report that they can afford such payments, and our extensive research supports their assessments. This research-based standard would ensure affordable payments while also creating a simple regulatory compliance mechanism that would allow banks and credit unions to profitably offer small installment credit to their customers at prices six times lower than payday loans.
In addition, representatives from more than half of the banks and bank branches in the U.S. supported the 5 percent payment standard in recent comments. Some banks and credit unions plan to use it to issue lower-cost loans at scale if regulators make it feasible. Although rates on those loans would be higher than those for credit cards—i.e., a $400, three-month loan would cost $50 to $60—more than 80 percent of both the general public and payday borrowers said such prices would be fair. Allowing traditional financial institutions to offer small installment loans using the 5 percent payment standard and other sensible safeguards would enable millions of consumers to stay in the mainstream banking system and save them more than $10 billion annually. These savings would exceed current spending on some major social programs, such as Head Start ($9.2 billion) or the Special Supplemental Nutrition Program for Women, Infants, and Children ($6 billion).
State legislators should rein in high-cost payday installment loans
The new rule is likely to accelerate the transition among payday and auto title lenders to high-cost installment loans. These lenders already issue such loans in half the states, typically at annual percentage rates of 300 to 400 percent, and the CFPB rule will not prevent them from doing so. Pew continues to recommend that legislators in these states reform their laws to rein in excessive prices, durations, and unaffordable payments and ensure that payday installment loans have lower costs and safer terms.
Lawmakers in Ohio, Nebraska, and Kansas have recently introduced legislation, modeled after Colorado’s successful reform, featuring affordable monthly payments using the 5 percent standard and sensible cost limits that are proved to be viable for lenders. Legislators in states that allow payday installment loans can save constituents millions of dollars each year by following suit. At the same time, the 15 states and the District of Columbia that already effectively prohibit payday lending should maintain rate caps that protect consumers; research does not show that changing those laws would benefit borrowers.
Nick Bourke directs and Olga Karpekina is a senior associate with The Pew Charitable Trusts’ consumer finance project.
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Results of a nationally representative survey of U.S. borrowers