Imagine you're making $30,000 a year, with two kids, a 15-year-old car and $1,300 rent. You manage your bills just fine most months, but a busted carburetor has thrown you for a loop. None of your relatives can float you the cash, nor will any bank loan you the money. But your neighborhood payday lender will, charging $15 for every $100 you borrow. All you have to do is repay the money with your next paycheck.
But it doesn't work out that way. Instead, a loan that you figured would only take a month tops to repay has taken six. You couldn't afford to repay the entire loan with your paycheck, so you paid a portion and rolled over the rest. In the end, you wind up paying over a hundred dollars in additional fees.
This scenario is increasingly a reality for millions of Americans, according to regulators and lawmakers, who are debating how to protect consumers from falling into a debt trap without eliminating their access to small-dollar credit.
At a Senate Banking Committee hearing Wednesday, Sen. Sherrod Brown (D-Ohio) said he was concerned that payday companies are marketing their high-cost loans to the very people who can least afford them, much like predatory mortgage lenders did in the run up to the housing crisis.
All most payday lenders require is that you have a steady stream of income and a checking account. They don't weigh your credit score or ability to repay the loan based on other financial obligations.
"We need ... robust consumer protections to ensure that these products are affordable and sustainable," Brown said, during the hearing on payday loans. "That means limits on costs, requirements consumers can repay their loans, products with longer repayment terms and the ability to pay down loan principal."
Everything Brown called for is exactly what advocacy groups want the Consumer Financial Protection Bureau to codify in regulation. It's been almost two years since the watchdog agency began supervising the payday industry, but the CFPB has yet to issue a set of long-awaited rules to govern lenders. The bureau has promised to have the rules out before the end of this year.
Not everyone is on board with placing restrictions on payday lenders. Some lawmakers say further regulations will stifle innovations that could drive down the price of the loans to the benefit of consumers. They say the tougher rules would reflect the government becoming a nanny state that dictates what products are best for Americans.
"God forbid we let people decide what is the most sensible thing to do in the circumstances they face," said Sen. Pat Toomey (R-Pa.), during the hearing. "There is a breathtaking, underlying arrogance in the presumption by wealthy people who have never been in those circumstances that they know better than those people who make these foolish decisions and borrow money from these institutions."
Toomey speaks for many Republicans, and some Democrats, who are uneasy about the prospect of the government dictating pricing (through interest rate caps) or limiting the number of payday loans Americans can take out at a time.
But a new report by the CFPB raises questions about the financial implications of the lending model. The study found that over 80 percent of payday loans are rolled over or followed by another loan within 14 days, based on a study of 12 million loans in 30 states.
The trouble is these borrowers are more likely to stay in debt for 11 months or longer, accruing more fees. That $15 charge to borrow $100 equates to about a 400 percent annualized interest rate, according to an earlier report by the bureau.
There are almost as many payday stores in the U.S. as there are McDonald's and Starbucks (no, really). Consumer groups say the astonishing growth of short-term lending is a reflection of stagnant wages and an uneven recovery that has left millions of Americans unable to meet basic living expenses. It also says a lot about the banking industry's inability to serve consumers who rely on these sorts of alternative financial products.
Banks are scrambling to figure out profitable ways to reach these so-called under-banked or un-banked communities. The few who offered their own form of payday loans, known as direct deposit advance, exited the business after regulators imposed tougher restrictions last year (the same sorts of rules the CFPB is considering for traditional payday firms).
While the payday debate rages on, there are a good number of small-dollar lenders who welcome federal laws, instead of the wide range of state laws that now exists.
"Innovative companies will create an array of credit products with flexible terms, payment options and loan amounts if they have a federal regulatory framework that encourages innovation rather than the current patchwork of state laws that stifles it," said Lisa McGreevy, president and chief executive of the Online Lenders Alliance.
But should federal rules supersede tough state laws that do more to protect consumers? That's for the CFPB to figure out. Stay tuned.