Payday and title lenders will be tasked with making sure their customers can actually afford their products.
Last week, the Consumer Financial Protection Bureau (CFPB) finally announced a new rule aimed at curbing predatory payday debt traps. The rule marks a large step forward for the bureau’s attempts to regulate the payday and title lending industries and to protect vulnerable consumers.
“The CFPB’s new rule puts a stop to the payday debt traps that have plagued communities across the country,” said CFPB Director Richard Cordray in a press release. “Too often, borrowers who need quick cash end up trapped in loans they can’t afford. The rule’s common sense ability-to-repay protections prevent lenders from succeeding by setting up borrowers to fail.”
“Only time will tell if these “full payment tests” will lower the number of full payment loans given to those who can’t pay them back,” says finance writer Jen Smith. “Someone will eventually find a way to manipulate it for their gain but I think it’s a step in the right direction and a sign the CFPB is still working to protect consumers.”
So, okay, awesome. But what does all of this actually mean?
Let’s break it down, shall we?
What are payday and title loans?
The new rule primarily affects payday loans and title loans, but it will also apply to deposit advance products and certain longer-term loans (up to 45 days) that feature “balloon payments” towards the end of the loan’s term.
If you’re not familiar with payday and title loans, then we’ll give you a brief refresher:
Payday loans are short-term, small-dollar personal loans. They usually have principals of a few hundred dollars, and the average length of their repayment term is only two weeks. Payday loans are no credit check loans, which means the lenders do not check a customer’s credit score during the loan application process.
The loans are designed to be paid back all at once, oftentimes through a post-dated check that the customer gives to the lender when the loan is issued or through a debit agreement wherein the lender can automatically withdraw the funds from the customer’s account.
If a customer can’t pay the loan back on time, they might be given the option to roll the loan over (extending the due date for an extra fee) or taking out another loan immediately after they’ve paid the first loan off.
Because payday loans charge interest over such a short repayment period, their annual percentage rates are astronomical compared to traditional loans. While their rates may vary, they’re often in the neighborhood of 300 percent or even higher!
Title loans are another kind of short-term loan that use the borrower’s car title as collateral. If the borrower cannot pay the loan back, the lender can seize their car and sell it in order to make up its losses.
Because they’re secured by collateral, title loans have much higher principals than payday loans. However, they are also built to be paid back all at once—a structure that’s known as “lump sum repayment.”
The average term of a title loan is only a month, but the average interest rate is 25%, which means that their average APR is 300%! If a borrower cannot pay their loan back, they might be forced to extend their loan, again and again, each time racking up additional costs without ever getting closer to paying down their original principal.
When the CFPB talks about the payday debt trap, they’re talking about situations like that.
The CFPB’s rule centers around the “full payment test.”
Payday and title loans are bad credit loans, which means that they’re aimed at people with low credit scores. These are folks who often have low incomes and little-to-no life savings, and their bad credit scores have cut them off from borrowing options at traditional lenders. When they encounter a financial emergency or find they can’t make ends meet, they see payday and title loans as possibly their only choice.
In situations such as these, it might seem like a blessing to them that payday and title lenders do not check their credit scores or their ability to repay their loan. Doing so might lead the lender to deny the customer’s application.
However, the CFPB sees things a little bit differently. They believe lenders should be checking a customer’s ability to repay their loan the first time—without rolling it over or reborrowing. That’s what their new rule is going to make lenders do.
Here’s how the CFPB’s new “full payment test” rule will work
The CFPB’s full payment test will require that lenders determine whether a customer can afford to repay their loan while also affording their other major financial obligations, including living expenses.
- For payday and title loans that require lump sum repayment, the CFPB is defining full payment as “being able to afford to pay the total loan amount, plus fees and finance charges within two weeks or a month.”
- For longer-term loans with balloon payments, the CFPB is defining full repayment as “being able to afford the payments in the month with the highest total payments on the loan.”
- Lenders will be required to “verify income and major financial obligations and estimate basic living expenses for a one-month period—the month in which the highest sum of payments is due.”
- The rule will also cap the number of loans that can be taken out by a borrower “in quick succession” to three.
- Once a borrower has reached their third loan, the CFPB’s rule will mandate a 30-day “cooling-off period” before they can take out another loan.
Lenders can skip the full payment test if they offer a “principal pay-off option.”
The CFPB will offer an exemption from this full payment test for certain short-term loans if the lender offers customers a “principal pay-off option.” This option is designed to get consumers out of debt gradually over time—more like traditional installment loans.
- If a customer can’t pay their loan off on time, they will be given the option of paying it off over two subsequent loans, each with a smaller and smaller principal amount.
- The customer will have to pay off at least one-third of their original balance with each loan.
- The rule will be restricted to loans with principals of $500 or less.
- These loans cannot use a car title as collateral or be structured as open-ended lines of credit.
- The lender is prohibited from offering this option over more than three loans.
- The rule also prohibits the lender from offering this option to a customer “if the consumer has already had more than six short-term loans or been in debt for more than 90 days on short-term loans over a rolling 12-month period.”
Some lenders and loans will be exempt from this rule.
The CFPB does carve out some space for lenders whose loan volume is either very small or who are already following guidelines meant to protect customers from predatory payday lending.
According to the CFPB’s press release, “These are usually small personal loans made by community banks or credit unions to existing customers or members.”
Lenders will be exempt if:
- They offer “2,500 or fewer covered short-term or balloon-payment loans per year.”
- They derive “no more than 10 percent of its revenue from such loans.”
- They are offering loans that “generally meet the parameters of “payday alternative loans” authorized by the National Credit Union Administration.”
The rule also “excludes from coverage certain no-cost advances and advances of earned wages made under a wage advance program.”
The rule institutes a “debit attempt cut-off”
This last feature of the CFPB’s new rules involves a lender’s attempts to continually debit a customer’s bank account for the amount owed.
The reason for this is simple: If a person is unable to repay their loan, repeated debits on their account will only rack up additional bank fees and could even lead to them losing their account altogether.
This section of the rule applies short-term loans, as well as any longer-term loan with an APR above 36%. It has two main features:
- After two straight unsuccessful debit attempts, a lender must stop debiting the account until they get a new authorization from the customer.
- If a lender is going to debit a customer’s account “at an irregular interval or amount”, they must first give them written notice.
“The rule is a great step forward in protecting consumers but we still have room to grow,” says Smith. “I suggest people never give a creditor your debit account information because they will not stop debiting your account until they’re paid in full. The debit attempt cutoff rule will save consumers a lot of fees associated with this problem.”
So what happens now?
Well, that’s a tricky question, isn’t it? The rules won’t fully take effect for 21 months—which means mid-2019. Between now and then, a lot could change. There could be lawsuits, for instance, or there could be attempts by the payday lending industry to compromise with the CFPB in return for some relief from regulation.
Director Richard Cordray’s terms will be up in 2018 before the majority of these rules are in effect. He was an Obama appointee, while his successor will be appointed by Trump. It’s safe to say that whoever ends up replacing might have fairly contrary views to those held by Cordray.
Certain corners of the payday lending industry are predicting a mini-collapse if these rules take effect. They claim razor-thin profit margins that won’t be able to withstand the burdens that these regulations place on them.
The biggest worry with this new rule is that customers for whom subprime loans are their primary access to credit will find themselves cut off entirely.
However, the biggest hope is that financial institutions of all sorts will rise to the occasion and start offering better, more affordable, more socially responsible products to customers with not-so-great credit.
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