After nearly four years of studying the issue of high-cost, short-term financial products like payday loans, and auto-title loans, the Consumer Financial Protection Bureau has finally released its proposed rules intended to prevent borrowers from falling into the costly revolving debt trap that can leave people worse off than if they hadn’t borrowed money in the first place.
The TL;DR Version
The proposed CFPB rules are intended to reduce the likelihood of borrowers falling into the trap of revolving debt associated with payday loans. There are two key aspects to the proposal:
1. Ability To Repay
Lenders would need to make sure in many cases that borrowers can not only repay the loan (plus fees and interest) in full and on time, but that they will have enough money remaining after repayment so that they don’t need another loan. However, this test is not applied to all loans, which some consumer advocates believe will create a loophole for predatory lenders.
2. Limiting Rollovers
Borrowers would need to demonstrate the need for a loan to be rolled-over or re-borrowed within a short period of time. Even approved rollovers would be limited to three in succession. Some critics are concerned that the 31-day window before re-borrowing will still allow borrowers to fall into a debt trap.
The proposed rules, which would lenders of payday loans, vehicle title loans, deposit advances, and certain high-cost installment and open-ended loans, build on the Bureau’s March 2015 report, which included options for reducing the likelihood of borrowers needing to take out new loans to cover the old ones, and falling victim to the often devastating cycle of debt associated with these financial products.
The Bureau is also taking aim at payment-collection practices that take money directly from bank accounts in a way that frequently hits the borrower with hefty fees.
“Too many borrowers seeking a short-term cash fix are saddled with loans they cannot afford and sink into long-term debt,” explains CFPB Director Richard Cordray in a statement. “It’s much like getting into a taxi just to ride across town and finding yourself stuck in a ruinously expensive cross-country journey. By putting in place mainstream, common-sense lending standards, our proposal would prevent lenders from succeeding by setting up borrowers to fail.”
Ending Debt Traps For Short-Term Loans
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Short-term, high-interest loans offer borrowers quick access to cash (often at a maximum of a few hundred dollars per loan) to cover expenses. When a borrower takes out a payday loan, they are effectively making a promise to repay that debt with their next paycheck (or within 10-14 days, whichever comes first).
However, more often than not, payday loan borrowers — who tend to be among the country’s most vulnerable consumers with few other credit options — are unable to repay the full debt, plus the often triple-digit interest, by the due date; or repaying in full leaves them unable to pay the bills for the next few weeks.
That’s why many payday lenders allow the borrowers to roll their debts over for an additional two-week period, while tacking on more fees, of course.
In 2014, the CFPB found that only 15% of borrowers were able to repay their debt when it was due without re-borrowing. By renewing or rolling over loans the average monthly borrower is likely to stay in debt for 11 months or longer.
Under its newly proposed rules, the CFPB offers four protections to end debt traps: a test that companies must perform before extending credit; restrictions on rollovers; a payoff option for some products; and offering less-risky lending options.
Full-Payment Test
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Under the proposed rules, companies that offer short-term loans would be required to follow an “ability-to-repay” protection that includes a “full-payment” test.
This test requires lenders to determine upfront if the borrower can afford the full amount of each payment when it’s due and still meet basic living expenses and major financial obligations. So not only must the borrower be able to repay the loan, they must have enough left over so that they don’t need to take out another loan.
When it comes to payday and single-payment auto-title loans, the full-payment means the borrower can afford the total loan amount, all the fees and finance charges, as well as meeting all living expense during the term of the loan and for 30 days after paying off the loan or paying the loan’s highest payment.
For installment loans with balloon payments — which are often for a higher dollar amount, the full-payment test requires the lender to ensure a borrower can pay all of the payments when due, including the balloon payment, as well as major financial obligations and basic living expenses during the term of the loan and for 30 days after paying the loan’s highest payment.
For installment loans without a balloon payment, lenders would be required to determine that a borrower can pay all of the installment payments when due, as well as major financial obligations and basic living expenses during the loan’s term.
Loan Rollover Options
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While some consumers may have a legitimate need to rollover their short-term loans, the CFPB’s rules are intended to prevent borrowers from falling into the trap of repeatedly taking out high-cost loans in quick succession.
To do so, the Bureau has created requirements for justifying additional loans, making it difficult for lenders to push distressed borrowers into re-borrowing or refinancing the same debt.
For payday and single-payment auto-title loans, if a borrower seeks to roll a loan over or returns within 30 days after paying off a previous short-term debt, the lender would be restricted from offering a similar loan.
Lenders could only offer a similar short-term loan if a borrower demonstrated that their financial situation during the term of the new loan would be materially improved relative to what it was since the prior loan was made.
So if a borrower is starting a new, higher-paying job in a couple of weeks, that may be a way for them to demonstrate that they won’t have to take out another loan after the rollover.
The same test would apply if the consumer sought a third loan. Even if a borrower’s finances improved enough for a lender to justify making a second and third loan, loans would be capped at three in succession followed by a mandatory 30-day cooling off period.
When it comes to installment loans, if the borrower is struggling to make payments, lenders would be prohibited from refinancing the loan into a loan with similar payment unless a borrower demonstrated that their financial situation would be materially improves compared to the 30 prior days.
However, the lender could offer to refinance if that would result in substantially smaller payments or would substantially lower the total cost of the consumer’s credit.
Principal Payoff Option
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For certain short-term loans, the CFPB’s rules would allow lenders to extend credit without first conducting the full-payment test. However, the option is restricted to only lower-risk situations that would require the debt to be repaid either in a single payment or with up to two extensions where the principal is paid down at each step.
Under the proposal, consumers could take out a short-term loan up to $500 without the full-payment test as part of the principal payoff option that is directly structured to keep consumers from being trapped in debt.
The specific parameters of the principal payoff option include:
• Restricted to lower-risk situations: Under this option, consumers could borrow no more than $500 for an initial loan. Lenders would be barred from taking auto titles as collateral and structuring the loan as open-end credit. Lenders would also be barred from offering the option to consumers who have outstanding short-term or balloon-payment loans, or have been in debt on short-term loans more than 90 days in a rolling 12-month period.
• Debt is paid off: As part of the principal payoff option, the lender could offer a borrower up to two extensions of the loan, but only if the borrower pays off at least one-third of the principal with each extension. This proposed principal reduction feature is intended to steadily reduce consumers’ debt burden, allowing consumers to pay off the original loan in more manageable amounts to avoid a debt trap.
• Debt risks are disclosed: The proposal would require a lender to provide notices before making a loan under the principal payoff option. These notices must use plain language to inform consumers about elements of the option.
Alternative Loan Options
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In addition to restricting when and how short-term loans can be handed out, the CFPB would permit lenders to offer two longer-term loan options.
Under the first option, lenders could offer loans that generally meet the parameters of the National Credit Union Administration “payday alternative loans” program.
These loans would come with an interest rate capped at 28% and the application fee is no more than $20.
The second option would be for lenders to offer credit that is payable in roughly equal payments with terms not to exceed two years and an all-in cost of 36% or less, not including a “reasonable” origination fee.
Lenders of this loan option would be required to have a projected default rate of 5% or less. If the default rate exceeds 5%, the lender would have to refund the origination fees for that year.
Lenders would be limited as to how many of either type of loan they could make per consumer per year, according to the CFPB.
Collection Protections
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While the proposed rule provides unique requirements for different lenders, the Bureau also tackled one of the more egregious and devastating aspects of small-dollar lending: collection practices.
Currently, both short-term and longer-term lenders often require access to consumers’ checking, savings or prepaid accounts before issuing credit. Such access allows the lender to collect payments directly from consumers in the form of post-dated checks, debit authorizations, or remotely created checks.
While this payment method may be convenient, it often leads to additional debt, as borrowers incur charges like insufficient funds fees, returned payment fees or account closure fees.
A recent CFPB study found that over a period of 18 months, half of online borrowers had at least one debit attempt that overdrafted or failed, and more than one-third of borrowers with a failed payment lost their account.
To alleviate these additional debt burdens, the Bureau’s new rules implement a debit attempt cutoff.
Under the proposal, lenders would have to provide borrowers with written notice before attempting to debit their account to collect payments for any loan covered by the rules.
This notice, which generally would be delivered at least three days before the withdrawal attempt, would alert consumers to the timing, amount, and channel of the forthcoming payment transfer.
The Bureau believes the proposed required notice would help to reduce harm that may occur from a debit attempt by alerting the consumers to the upcoming attempt in sufficient time for them to contact the lender or the consumer’s bank if there are any mistakes. It would also allow them time to make arrangements to cover payments that are due.
After two straight unsuccessful attempts, the lender would be prohibited from debiting the account again unless the lender gets a new and specific authorization from the borrower.
According to the CFPB, this protection would prevent the borrower from being assessed between $64 and $87 in overdraft or insufficient funds fees.
Will The Protections Work?
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Consumer advocates, who have long pushed for payday-related rules, are taking a cautiously optimistic view of the CFPB proposal, with the National Consumer Law Center calling the proposal a “strong start,” but warning of potential loopholes.
NCLC associate director Lauren Saunders says she appreciates a common-sense approach to the ability-to-repay rule, but believes all loans should be held to that test. Similarly, NCLC raises concerns about allowing people to re-borrow in as little as 31 days, as that would still be an indicator of a “debt trap.”
Similarly, Mike Calhoun, president of the Center for Responsible Lending, warned that “the devil, as always, is in the details. There is still a great deal of work to be done on this proposal to ensure it truly protects consumers from the devastation wrought by high-cost, low-dollar predatory loan products.”
Hilary Shelton, NAACP executive vice president for policy, was more consistently positive in expressing her organizations’s support.
“This rule has the potential to make a significant and positive impact in the lives of ordinary Americans, particularly racial and ethnic minority Americans, by protecting them from financial predatory lenders,” said Shelton, who stressed the importance of making sure a strong ability-to-repay requirement makes it into the final version of the rule.
Speaking of which, advocates, lenders, and consumers will have the chance to weigh in.
More Work To Be Done
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While the payday rules are almost finished, the Bureau will continue to explore other options and protections for consumers and financial products.
In addition to unveiling the proposed rules, the Bureau launched today an inquiry into other potentially high-risk products and practices not covered by the proposal.
The request for information focuses on two areas: concerns about risky products, such as high-cost, longer-duration installment loans, and concerns about risky practices that could impact a borrowers’ ability to pay back their debt, such a methods lenders use to seize wages, funds, and vehicles, as well as sales and marketing practices of add-on products.