The CFPB’s rules should protect borrowers and foster access to better forms of small credit with affordable payments.
In spring or summer of 2016, the Consumer Financial Protection Bureau (CFPB) will publish an official notice of proposed rule-making to establish federal regulations for payday and similar loans for the first time since these products emerged in the early 1990s. In a framework published in March 2015, the bureau made clear that high-cost payday and auto title lending will continue but with new safeguards intended to protect against harmful practices that are pervasive in today’s market. The bureau will most likely finalize the rules nine to 12 months later.
How the CFPB finalizes its rules will determine whether small-dollar lending will transform into a safe and reliable financial market. The rules will probably prevent some harmful loans from being issued, but to ensure that the millions of loans that are made are affordable and have fair and reasonable terms and conditions, the CFPB will have to set clear, measurable, and enforceable guidelines.
The CFPB framework lets lenders choose how to comply
According to the CFPB’s framework, the new rules will apply to all “covered loans” from any lender. Covered loans include certain short-term loans of 45 days or less and longer-term loans of more than 45 days that (1) have an “all-in” annual percentage rate (APR)—a rate that includes the cost of all fees and insurance—of more than 36 percent and (2) are effectively secured by the borrower’s checking account or vehicle title. When making a covered loan, lenders will be required to choose from two options:
- “Ability to repay” underwriting process. Lenders must document the borrowers’ income and certain expenses and make a “reasonable determination” that the loan payments will fit within their means, but the CFPB will not impose limits on the cost, size, or duration of loans; payment amounts; or the length of time lenders have access to borrowers’ checking accounts or car titles. In other words, lenders will be able to set any loan terms they wish as long as they complete the required documentation process and determine that the borrower can afford the required payments. Regulatory examiners will be responsible for monitoring lenders for signs of unreasonable lending practices, but unless the bureau outlines clear metrics for identifying violations, those reviews may not produce meaningful enforcement or deliver significant protection for consumers.
- “Alternative requirements.” Instead of dictating an underwriting process, this option features more objective guidelines for ensuring that loans are structured to meet general ability-to-repay standards. The alternative requirements include restricting borrowers to three consecutive short-term lump-sum loans and a maximum of six per year, and for loans lasting longer than 45 days, defining affordable payments as no more than 5 percent of the borrower’s monthly income and reasonable loan durations as six months or less. These options, as well as other parts of the initial framework, may change as the CFPB finalizes its rules.
High-cost loans will remain widely available
The CFPB does not have the authority to ban high-cost credit or to regulate interest rates. Instead, its framework sets conditions lenders must satisfy when making these loans in order to prevent some applicants from getting loans that could be harmful. Although the bureau wisely made borrowers’ ability to repay the central theme of its framework, it has not yet established sufficiently clear, objective, and enforceable guidelines describing the quality of loans that people actually receive.
If finalized according to the framework, the bureau’s rules would give high-cost lenders unusually strong leverage in the form of direct access to customers’ checking accounts or vehicle titles, which would allow them to collect payments and generate profits even when loans are unaffordable for borrowers. The ability to take money directly from checking accounts or repossess a vehicle means high-cost lenders would tend to get paid regardless of the customers’ financial circumstances or priorities. This, in turn, would insulate lenders from the damaging effects of unaffordable loans, such as defaults and losses, while borrowers would bear the brunt and would often be left unable to pay other bills or purchase food or other necessities.
This structure would also make it difficult for the CFPB and other regulators to identify when a lender is engaging in unfair or aggressive underwriting practices because lenders’ balance sheets appear healthy, while customers would suffer the consequences of unaffordable payments, hardships that would be largely undetectable by regulators. Industry analysts have credibly forecast that most payday loan borrowers would pass through the ability-to-repay underwriting process and receive a loan, meaning millions of Americans would be subject to excessive prices and potentially harmful loan terms even under the CFPB rules.
For these reasons, Pew supports the CFPB’s “alternative requirements” for loans lasting longer than 45 days as outlined in the March 2015 proposal, which because of their objective standards for affordable monthly payments and reasonable durations, represent the safest and clearest part of the framework. If finalized in the rules, these guidelines would not only provide greater protection to customers seeking credit in the existing small-loan marketplace, they would also enable lower-cost lenders such as banks and credit unions to make new types of installment loans at prices far below those of payday lenders.
In short, the CFPB must strengthen its proposed ability-to-repay standards as well as preserve and improve its alternative requirements for longer-term loans.
Key questions to ask when the CFPB publishes its payday loan rules
The CFPB’s rules should protect borrowers and foster access to better forms of small credit with affordable payments. To be successful, the bureau must ensure that the answers to the following questions are yes:
- Do the rules stop the most harmful payday loan practices and establish clear guidelines for new, lower-cost products to enter the market?
- Do the “ability to repay” underwriting standards screen out prospective borrowers who cannot afford more debt and provide clear protections for those who do receive credit? Do they include clear and easy-to-enforce guidelines for affordable payments and reasonable durations? Do they help ensure that after making their payments, borrowers will still have enough money each month to cover child care, transportation, medical care, and other necessities?
- Do the “longer-term alternative” guidelines support lower-cost bank and credit union options? Do they go beyond simply accommodating the handful of small loan alternative programs that exist today and provide clear rules on affordable payments and reasonable durations to encourage the introduction of new types of small installment loans that have the potential to help millions of Americans?
Pew will continue to evaluate the rules as they develop.
Nick Bourke directs the small-dollar loans project at The Pew Charitable Trusts.