Pew Identifies 4 Risks in Shift to Payday Installment Lending

WASHINGTON—The shift toward installment credit in the payday and auto title lending markets is creating new risks, but a draft rule proposed in June by the Consumer Financial Protection Bureau (CFPB) would not adequately protect borrowers because it does not keep pace with changes in the industry, according to an issue brief released today by The Pew Charitable Trusts.

The analysis identifies four primary loan characteristics that harm consumers: unaffordable payments, front-loaded fees, excessive durations, and unnecessarily high prices. The brief outlines the reasons for the shift to installment lending, highlights the riskiest practices, and identifies actions that the CFPB and other policymakers can take to counter these harms.

The CFPB proposed rule would require most small loans to be repayable in installments, which would represent a significant improvement, but that change alone is not enough to make these loans safe. In 13 of the 39 states where they operate, payday and auto title lenders issue only high-cost, single-payment loans, but in the other 26, they are already making installment loans with annual percentage rates (APRs) of 200 to 600 percent. These high-cost installment loans would still be permitted under the CFPB standards.

The brief, “From Payday to Small Installment Loans: Risks, Opportunities, and Policy Proposals for Successful Markets,” shows that unaffordable payments can lead to the same types of problems as conventional payday loans: frequent re-borrowing, heavy use of overdrafts, and the need for a cash infusion to retire debt. Large upfront origination fees effectively penalize borrowers who repay early or refinance, while unreasonably long durations can double or triple borrowers’ costs. Because payday and auto title lenders typically compete on location, customer service, and speed rather than on price, costs for these products, like conventional payday and auto title loans, are unnecessarily high, such as more than $1,000 in fees for a $500 loan.

“The payday loan market is rapidly shifting away from lump-sum lending toward installments, but 400 percent APR payday installment loans can be harmful too,” said Nick Bourke, who directs Pew’s small-dollar loans project. “To protect consumers, the CFPB should add clear product safety standards to its rule, such as limiting installment payments to 5 percent of a borrower’s paycheck. This safeguard would make existing loans more affordable and enable banks to offer comparable small credit at prices six times lower than payday lenders, saving millions of borrowers billions of dollars annually.”

Pew recommends the following policies to address the four main challenges posed by installment loans:

• Establish clear ability-to-repay standards, limiting loan payments to an affordable percentage of a borrower’s periodic income. For most borrowers, monthly payments above 5 percent of gross monthly income are unaffordable.
• Allow only interest charges or monthly fees on the loan, and no other fees. Origination fees and other front-loaded charges penalize borrowers who repay early and make the first month of a loan by far the most profitable for lenders. This creates a strong incentive for lenders to encourage borrowers to refinance rather than pay off their loans, a practice known as loan flipping.
• Require loans to have reasonable repayment durations. Colorado reformed payday lending in 2010, and its experience has demonstrated that even at high interest rates, six months is generally long enough to pay back $500.
• Enact price limits and enable lower-cost providers to enter the small-dollar loan market. Unlike the CFPB, state lawmakers have the power to regulate interest rates or ban payday lending. At the federal level, the CFPB and other regulators should allow banks and credit unions to offer small installment loans using simple, highly automated underwriting at prices that are fair to financial institutions and consumers. Research indicates that, if provided with clear, consistent regulations, banks and credit unions can profitably make such loans at prices that are six to eight times lower than those offered by payday lenders.

The CFPB’s Notice of Proposed Rulemaking for small-dollar loans is open for public comment until Oct. 7, 2016.

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The Pew Charitable Trusts is driven by the power of knowledge to solve today’s most challenging problems. Learn more at www.pewtrusts.org/small-loans.