The idea seems simple enough. Businesses lending money should make sure borrowers can actually afford to pay back loans. But enforcing such a practice has largely eluded regulatory agencies as the post-recession credit crunch has proved to be a boon for predatory lenders.
While the issue of predatory lending to small business owners is only now making its way to policymakers, governments have made significant progress over a decade in cracking down on similar lending practices to consumers. Still, results have varied and many hope that the recent federal proposal outlined by the Consumer Financial Protection Bureau will be a national solution to eliminate payday lending practices that result in debt traps. The proposal would require lenders to verify key information like a consumer’s income, borrowing history and whether she can afford the loan payments.
“As Americans, we don't mind folks making a profit,” said President Barack Obama last month at a speech outlining the proposal. “But if you're making that profit by trapping hardworking Americans in a vicious cycle of debt, then you need to find a new business model. You need to find a new way of doing business.”
The federal proposal is a significant step in an effort in which states have been engaged for more than a decade. The bureau can’t set interest rate caps on loans -- that is still up to states. But over the last two years, the bureau has studied the payday lending market and its impact. Many anticipated its proposed rules would provide the kind of ability-to-pay reforms levied on the mortgage lending industry after the subprime crisis.
Payday loans are, as the name suggests, due on the next payday. Interest rates are typically masked. For example the lender may give 20 percent as a rate, but that is actually a monthly rate, meaning the actual APR is 240 percent. (By comparison, credit card companies often charge an APR between 20 and 30 percent.) On top of that, additional check costs and fees can be hard to find or confusing for the borrower. The lenders make loans with little (if any) regard to the borrower’s ability to repay that loan and meet other obligations. When the loan comes due, the lender immediately deducts the loan and costs from the borrower’s paycheck. In many cases, this means the borrower can’t cover all his expenses for the next two weeks. So he turns back to the payday lender for more cash.
It's not unusual for a $300 loan to be rolled over multiple times and ultimately cost more than $800 in principal and interest, said the Center for Responsible Lending (CRL), a North Carolina advocate for reform. Diane Standaert, a payday loan expert for CRL, notes that payday lending’s business model is marked by excessive fees, levels of repeat refinance and making loans based on collateral (like a car) versus the borrower’s ability to repay. “These are the hallmarks of predatory lending,” she said.
Multiple studies have found that the typical payday borrower is indebted for more than 200 days out of the first year they seek a loan. Such repeat borrowing comprises the bulk of the industry’s revenue -- about three in four payday loans are due from borrowers who have taken out more than 10 loans in a single year. This practice is called “loan churn” and the CRL estimates that more than two-thirds of the $3.4 billion in fees lenders charge every year is from loan churn.
So far, 16 states and the District of Columbia have enforced an interest rate cap on loans, a method that many experts say is the most effective way to curb payday lending. Six other states have enacted other reforms that limit the market. Delaware and Washington state, for example, have limited the number of payday loans that a borrower can take in a single year.
Despite these actions, states have found that payday lenders evolve quickly and make ample use of loopholes. “You try to stop them but they just become something else,” said Brenda Procter, a payday lending expert at the University of Missouri. “They’re just this many-headed monster.”
In Montana, where many loan shops shut down when the state passed a 36 percent APR cap in 2010, payday lenders are now popping up on Indian reservations to avoid state regulation. A report by Policy Matters Ohio found that most lenders avoided that state’s 28 percent APR rate cap by offering their service as a mortgage lending license. Or they tried to skirt the state’s definition of payday loans, which is loans that are $500 or smaller. “In order to be able to charge higher fees, some stores did not offer loans at $400 or $500,” the report said. “When asked about a $500 loan, our testers were often told that they would need to borrow $501 or $505.”
This state-by-state morphing ability of the payday lending industry is a big reason that advocates now are placing a lot of hope in the proposed regulations by the Consumer Financial Protection Bureau. When asked if payday lenders would simply find ways to skirt around the federal regulations as they have with state ones, Center for Responsible Lending President Mike Calhoun pointed to the bureau’s “substantial” enforcement powers. “This is a nationwide effort,” he said on a conference call earlier this month. “So I think this will be different.”