Is the CFPB about to break the payday lending business model?

Whenever governments start thinking about cracking down on small-dollar, high-interest financial products like payday loans and check cashing services, a shrill cry goes up from the businesses that offer them: You're just going to hurt the poor folks who need the money! What do you want them to do, start bouncing checks? 

A field hearing held by the Consumer Financial Protection Bureau today was no exception. The young agency has been studying how the industry functions for a couple years and is now very close to issuing new rules to govern it. To start setting the scene, CFPB Director Richard Cordray came to Nashville — the locus of intense payday lending activity recently — to release a report and take testimony from the public.

The report, building on a previous white paper, is fairly damning: It makes the case that "short term" loans are usually not short term at all, but more often renewed again and again as consumers dig themselves into deeper sinkholes of debt. Half of all loans, for example, come as part of sequences of 10 or more renewed loans — and in one out of five loans, borrowers end up paying more in fees than the initial amount they borrowed.


This is a simple graph, but makes an important point: A solid majority of borrowers end up rolling over their loans after they come due, which gets expensive. (CFPB)

Faced with a barrage of data, the industry defended their products as an essential option for people living paycheck to paycheck. Many in the hearing audience at the Country Music Hall of Fame wore yellow stickers with the slogan "I choose payday advance."

"You see so many different stories that come through, and you're able to help people in a time of need," said Heath Cloud, who said he'd been in the payday loan business for 13 years. "I'm so grateful to then see that smile, that relief on their face when they leave my office, because I was able to help them. That's why I enjoy what I'm doing."

The message: Destroying this form of credit will mean more late mortgage payments, more foregone medical procedures, more missed days of work when someone couldn't pay for gas. But here's the thing. Cordray doesn't want to get rid of payday loans either — he said they "can be helpful for the consumers who use them on an occasional basis and can manage to repay them" — and he doesn't have to in order to make them safer for consumers. 

Based on advocates' positions and previous regulatory actions, like provisions of the Military Lending Act for servicemembers, the industry's greatest fear is that the CFPB's rule will include a strict interest rate cap of 36 percent APR — dramatically less than the 400 percent they usually charge, amounting to just a few dollars on top of a $100 loan.

"The truth of the matter is that no lender can operate in a market with those aggressive price caps or restrictions," said Amy Cantu, a spokeswoman for the Consumer Financial Services Association of America, which represents a majority of payday lenders. "We can't pay our employees, we can't pay our utilities, we can't pay our rent. Regulated, licensed entities are effectively banned." (The Association also protested that the CFPB had not waited to incorporate its members' data into its report.)

Passing a rate cap, however, is not the only remedy. In fact, it's not even possible: The CFPB is barred by statute from doing so.* And actually, the Pew Charitable Trusts — which has been tracking payday lending for years — doesn't even think it's the best approach.

"The core problem here is this lump-sum payday loan that takes 36 percent of their paycheck," says Pew's Nick Bourke, referring to the average $430 loan size. "The policy response now has to be either eliminate that product altogether, or require it to be a more affordable installment loans." 

Bourke favors the latter option: Require lenders to take into account a borrower's ability to repay the loan over a longer period of time, with monthly payments not to exceed 5 percent of a customer's income. That, along with other fixes like making sure that fees are assessed across the life of the loan rather than up front, would decrease the likelihood that borrowers would need to take out new loans just to pay off the old ones.

Now, the installment loan plan wouldn't leave the industry untouched. When Colorado mandated something similar, Pew found that half of the storefront payday lenders closed up shop. But actual lending didn't decrease that much, since most people found alternative locations. That illustrates a really important point about the small dollar loan industry: As a Fed study last year showed, barriers to entry have been so low that new shops have flooded the market, scraping by issuing an average of 15 loans per day. They have to charge high interest rates because they have to maintain the high fixed costs of brick and mortar locations -- according to Pew, 60 percent of their revenue goes into overhead, and only 16 percent to profit (still quite a healthy margin). If they were forced to consolidate, they could offer safer products and still make tons of money.


(Pew Charitable Trusts)

Meanwhile, there's another player in the mix here: Regular banks, which got out of the payday lending business a few months ago in response to guidance from other regulators. With the benefits of diversification and scale, they're able to offer small-dollar loans at lower rates, and so are better equipped to compete in the market under whatever conditions the CFPB might impose.

It's true, these changes could result in a serious retrenchment for storefront payday lenders. Many, many small businesses would not survive, which is why groups like the CFSAA have instead asked the CFPB to simply codify its best practices into law — they prevent the worst abuses, but still allow a fairly inefficient industry to maintain the status quo.

If Cordray's remarks are any indication, that's not in the cards. "The business model of the payday industry depends on people becoming stuck in these loans for the long term, since almost half their business comes from people who are basically paying high-cost rent on the amount of their original loan," he said. "Loan products which routinely lead consumers into debt traps should have no place in their lives." 

* Updated to reflect that the Dodd-Frank Act prohibits the CFPB from imposing usury caps. 

Lydia DePillis is a reporter focusing on labor, business, and housing. She previously worked at The New Republic and the Washington City Paper. She's from Seattle.
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