Colorado's Payday Loan Reforms Offer Blueprint for CFPB

The Consumer Financial Protection Bureau can learn a lot from the Centennial State.

The agency is currently in the process of developing new regulations for payday lenders. It would be well served to model its proposed rules after Colorado's. The meaningful reforms that state's lawmakers implemented in 2010 have dramatically improved outcomes for payday loan borrowers while still maintaining consumers' access to credit.

More than four years later, payday loan borrowers in Colorado are spending 42% less in fees, defaulting less frequently and paying lenders half as much in penalties for bounced checks as before the reforms took effect, according to an analysis of Colorado regulatory data. These consumers still have ready access to small-dollar loans. Installment payments average less than $50 biweekly, roughly one-ninth the size of payments required by lenders in other states.

The CFPB has a historic opportunity to fix the small-dollar loan market by emulating Colorado's example. That would entail requiring that all payday and similar loans have payments that are much smaller and more affordable than is currently the case.

It would also mean enacting protections against deceptive practices like loan flipping, in which lenders encourage borrowers to refinance their loans in order to generate new origination fees or to mask a potential default for those who are struggling to make a payment. As former CFPB Deputy Director Raj Date recently noted, uniform regulations that eliminate deceptive practices in the small-dollar loan market are the key to enabling newer, better products.

Borrowers are eager for regulators to act, according to a nationally representative survey of 703 payday loan customers conducted by The Pew Charitable Trusts in 2012. Payday loan borrowers overwhelmingly favor new regulations. Eight in ten support requirements that loans be repayable over time in installments that consume only a small amount of every paycheck. Most borrowers cannot afford to put more than 5% of their pretax paycheck toward each loan payment without having to borrow again to make ends meet, according to Pew's calculations based on data from surveys and market research.

The CFPB can adopt Colorado's affordable-payments model without copying its exact legal code. The agency could require payday lenders to adhere to specific loan durations depending on the amount borrowed. It could also mandate that lenders determine that each borrower has the ability to repay before extending credit or explicitly require affordable loan payments, such as limiting periodic payments to no more than 5% of the borrower's periodic pretax income.

These measures have been unnecessary in the 14 states, along with the District of Columbia, that have upheld traditional usury interest rate caps. Interest rate limits continue to be an important policy tool for improving small-loan markets. But that is not an option for the CFPB, which does not have the legal authority to regulate interest rates.

Meanwhile, balloon-payment payday loans in 35 states continue to harm borrowers. Only Colorado has figured out how to make payday loans available in a relatively safe and transparent fashion.

Colorado also has provided lessons on how not to implement payday loan reform. The state's 2007 attempt to overhaul the payday lending industry failed. That effort allowed lenders to continue making conventional, balloon-payment loans, but required them to offer an installment plan after making four consecutive loans.

As a recent report from The Pew Charitable Trusts shows, this approach did not work. Balloon-payment loans continued to dominate the market, and outcomes for borrowers changed only slightly. The policy's failure can be largely attributed to its attempt to treat the symptom — repeat borrowing — without addressing the disease. The real problem was an unaffordable balloon payment that consumed more than a third of the next paycheck of a borrower who was already in financial distress.

When Colorado legislators tried again in 2010, they tackled the core problem of affordability. In addition to the reduced costs of payday loans and the decline in defaults and bounced check fees, the state experienced a 40% decrease in same-day loan renewals. These are demonstrably better results for the people who take out payday loans — which helps explain why the Colorado borrowers that Pew interviewed are satisfied.

Colorado lawmakers achieved these results by imposing principles that ought to be obvious but have been forgotten in every other payday loan market. In sum, all loan payments should be tailored to fit into borrowers' budgets and lenders should not be able to boost profits or mask defaults through loan flipping.

That is exactly the right model for federal regulators to follow.

Nick Bourke is director of the small-dollar loans project at The Pew Charitable Trusts. Follow him on Twitter @nibosays.