The Consumer Financial Protection Bureau’s (CFPB) payday lending rule goes into effect next week.
The rule has two parts:
- Payday lenders must “reasonably determine” the borrower’s ability to repay the loan. This includes taking the borrower’s credit history and spending habits into account when making a loan.
- Payday lenders cannot attempt to withdraw payment from a borrower’s account, without the borrower’s authorization, after two consecutive attempts have failed.
This rule sounds fairly common sense. Payday lenders hardly derive our deepest feelings of empathy. On the surface, they are the embodiment of unrestrained greed and capitalism in its worst form. Why do payday lenders exist in the first place?
Payday loans are a short form of credit. The borrower gets funds quickly, with the promise to repay within the next few weeks. How do they work? Borrowers write a personal check for the principal and interest charge, dated with their next payday at work. On that payday – when the borrower has the funds in their checking account – the lender cashes the check for the principal and interest.
Yesterday, the pipes in my townhouse froze (it’s those weak-willed Northern Virginia pipes – the pipes in the Midwest laugh at you, Northern Virginia pipes!). I could choose to pay the plumber by cash or credit card.
Payday borrowers rely on credit to finance much of life’s happenings as well. In fact, a survey of payday borrowers found that 86% strongly or somewhat agreed that their use of the payday loan was due to an unexpected expense (page 35). Payday customers use the loans to smooth consumption, not to buy superfluous goods.
Let’s consider the unintended consequences of CFPB regulation of payday loans.
Take the CFPB’s lament that payday loans can top $400% Annual Percentage Rate (APR). That sounds like “gouging” but doing the math clears things up. Consider a payday loan principal of $300 to fix your frozen pipes. You promise to repay $350 in two weeks ($50 of interest). This calculates out to around 434% APR. But recall from earlier: the payday loan is intended to be short-term financing to be paid back on the next payday. It isn’t intended to be financing for a whole year. The CFPB using APR as a measure in the payday industry is akin to your Airbnb host explaining the monthly rental rate when all you’re looking for is a weekend stay.
Wouldn’t payday borrowers be better off using cash or a credit card like me? Payday borrowers are typically low on expendable cash. Credit cards are costly, too. Credit cards require quality credit history and proof of particular levels of income. Those that choose payday loans don’t do so because they are uninformed. They likely don’t qualify for more traditional forms of credit. What’s more, the fees involved with payday loans are clearly delineated, unlike the surprise overdraft and credit card fees.
This makes the CFPB’s rules problematic for borrowers. Increasing the strictness of ability to pay rules will likely lock many borrowers out of the payday market – a market that for many is the last legal recourse for credit. It’s hard to argue that this makes borrowers, already in a bad situation, better off.
The CFPB qualifies their rule with the statement “The rule allows less risky loan options, including certain loans typically offered by community banks and credit unions, to forgo the full-payment test.” In an ideal world, payday customers would choose less risky loan options. The CFPB believes that the strict payday rules will push borrowers to more traditional forms of credit. The reality is that payday customers choose risky credit options on purpose – namely that they either would not qualify for the less risky loan or their particular situation calls for quick cash a payday loan provides.
It is poor reasoning for the CFPB to assume payday borrowers are leaving less costly, less risky options for credit on the table to choose a payday loan. Further, if less costly lenders thought that they could make a profit lending to payday borrowers, they would do so without the CFPB suggesting that they do. The motives of the “greedy” payday lender are no different than the associate at the community bank or credit union.
On the lender side, we can expect fewer payday lenders. Running credit checks, documenting spending habits and following up with borrowers is costly in both time and money. Additionally, limiting lenders’ access to recoup payments will drive up the risk of origination in the first place.
CFPB regulation also increases compliance costs and risk for payday lenders. A quick look at the CFPB’s website shows that they do not take kindly to violations. To quote The Big Lebowski, “This is not Nam, this is bowling, there are rules”. Payday lending is already an industry filled with high amounts of risk. Additional CFPB oversight (and the fines that tag along for the ride) makes operating within the industry more costly.
Evidence shows that payday lenders do not enjoy outrageous profit margins (page 2). Higher origination, repayment and compliance risk and cost will drive many payday lenders from the market. Those that remain will likely focus their business on safer borrowers. The riskiest of borrowers – also the most vulnerable – will pay the price.
The CFPB’s new payday lending rules make for a pretty press release but come with heavy baggage of unintended consequences. We all want the most vulnerable among us to be better off. However, the CFPB’s well-intentioned new rules may limit options for those who already have so few.