Predatory lending dominated the news last week with the Consumer Financial Protection Bureau releasing a proposal to rein in the unfair and abusive practices of payday, car title and high-cost installment loans. Hours after the CFPB unveiled its proposal, President Obama spoke in Birmingham, Ala., against those who trap "hardworking Americans in a vicious cycle of debt."
The government's push to require payday and other high-cost lenders to establish borrowers' ability to repay their loans as is already the practice among responsible lenders is both welcome and long overdue.
There is nothing radical or extraordinary about the CFPB's proposal. Until relatively recently, states had usury laws that covered all lending. Only in the last 25 years have a number of states exempted small-dollar loans from interest-rate caps. The result is loans with staggeringly high annual interest rates that average 391%.
Small-dollar lenders gained exemptions from interest-rate caps based on the premise that the loans would be short-term, emergency credit for borrowers in a cash crunch before their next payday. But the experience of borrowers has been far different than promised or imagined.
Studies from independent research organizations and the CFPB itself expose a business model that relies on loans that borrowers cannot repay without being forced to re-borrow to meet ongoing expenses. Fully 75% of payday lenders' revenues come from borrowers who take 10 or more loans per year. Our own analysis of lender data shows that the typical payday loan borrower pays back a two-week loan over seven months. To borrow $325, the average consumer will pay $468 in interest and fees.
With direct access to borrowers' bank accounts, alternative lenders can reach into a consumer's account as soon as a paycheck clears. This all too often leaves borrowers with little to cover ongoing essential expenses such as food and utilities, leading to a cycle of debt that is difficult to break.
The CFPB's proposal simply returns the market to basic principles of responsible lending. The centerpiece of the proposal calls for lenders to assess a borrower's ability to repay by documenting income and fulfilling other obligations. To ensure that the loans are affordable, the bureau also requires borrowers to take a 'cooling off' period of two billing cycles after their third consecutive loans unless the borrowers can show a change of circumstances such as higher income or reduced obligations.
The proposal does have a potentially fatal flaw. The CFPB's proposal includes the option of allowing lenders to ignore the ability-to-repay standard for loans that are under $500 and meet certain other criteria. This option could undermine efforts to push alternative lenders to develop fair and affordable credit products. To exempt some of the riskiest loans on the market from an ability-to-repay determination makes little sense and is a departure from CFPB practice.
In addition, the CFPB should go further in ensuring that alternative lenders' underwriting is working as intended and that the loans are affordable for borrowers. The proposal contemplates imposing a limit of three loans, after which customers must take a "cooling-off" period of sixty days before borrowing more. For short-term loans, the proposal also includes a limit of 90 days of indebtedness per year. But these are offered as alternatives to proper underwriting. These provisions should not be performed in isolation of each other. Instead, they should work in tandem.
In sum, the CFPB's proposed reforms are at once unremarkable and critically important. Requiring the small-dollar loan market to responsibly check a person's ability to repay the loan is basic common sense-such a requirement must not be optional. At the same time, the agency should also require a check on the affordability of these loans with additional measures that ensure borrowers have an end to the debt trap, such as imposing limits on rollovers. Such requirements will spark incredible innovation in what has become a predatory marketplace.
Michael Calhoun is the president of the Center for Responsible Lending. Follow him on Twitter @CRLMike.