For Lenders

Why Both Installment And Payday Loans Are Under Regulatory Scrutiny

Mar. 27 2016

Both payday loans and installment loans are often described as “small dollar, high-cost loans,” because they are usually for relatively small amounts of money at high rates of interest.

There are many options, but a payday loan will typically be for an amount between $100 and $1,500 dollars for a period of no more than 30 days. As the term “payday” suggests, the idea is that the loan should be repaid when the borrower receives their next paycheck – typically within two to four weeks. The payday loan industry is currently estimated to be worth approximately $38 billion.

Installment loans are generally for larger sums – even several thousand dollars – and allow longer repayment periods. The loan is repaid in fixed installments over a period that ranges from a few months to several years, depending on the size of the loan and other factors.

If a borrower just needs a little short-term cash, perhaps for some kind of household emergencies such as a house or car repair, and they have a predictable source of regular income, then a payday loan can make sense if the borrower is unable to access more conventional lines of credit.

But there’s no doubt that payday loans carry a higher interest rate compared with credit cards or installment loans, for which typical annual interest rates can range between 5 percent and 40 percent, depending on the borrower’s credit score and other factors.

For payday loans, however, depending on the lender and state regulations, borrowers could be paying anywhere between $15 and $30 per $100 borrowed. It might not sound like a lot (and when someone needs emergency cash, it’s often cheaper than overdraft fees or losing a job due to not having car repairs), but the annual percentage rate (APR) of short terms loans looks staggering. And if the borrower fails to repay the loan on the due date, as some do, and starts rolling it over to the next paycheck, the debt owed can grow very quickly.

For these reasons, regulators appear to be trying to clamp down on payday and auto title loans.

In June 2016, the Consumer Financial Protection Bureau (CFPB) put forward a rule that would require lenders to meet an onerous “ability to repay” standard. In simple terms, the rule would require the lender to ensure that their customers will be able to repay their loan in full on the due date.

Under the so-called ability to repay analysis (also called the “full payment test”), lenders would have to perform credit checks and also obtain information about borrowers’ other financial commitments and necessary day-to-day spending.

For loans of less than $500, a “Principal Pay Off” option would be available as an alternative to the full payment test. Lenders would not be allowed to use an auto title as collateral, and the loan would have to be designed so that borrowers can pay back the full amount at once or with a maximum of two extensions.

This option would only be available to lenders who do not have pre-existing short-term loans that are not yet paid off.

The new regulations would also prevent repeated attempts to debit customers’ accounts, which, if unsuccessful, may lead to the charging of further fees and therefore an increase in debt.

Unsurprisingly, the proposals have attracted fierce criticism from the payday loan industry, which argues that the regulations are too restrictive and harmful to people on low incomes or with a bad credit history.

Dennis Shaul, CEO of the Community Financial Services Association of America (CFSA), recently said:

The CFPB’s proposed rule presents a staggering blow to consumers as it will cut off access to credit for millions of Americans who use small-dollar loans to manage a budget shortfall or unexpected expense. It also sets a dangerous precedent for federal agencies crafting regulations impacting consumers.

But it’s far from clear that payday loans will be completely replaced by installment loans any time soon. Democratic presidential candidate Hillary Clinton has warmly endorsed the proposed regulations, but there’s no doubt that they will face significant challenges from Republicans.

Moreover, high-rate installment loans have also attracted some severe criticism. The National Consumer Law Center (NCLC) argues that a reasonable loan market requires an alignment between the interests of the borrower and lender. In other words, the lender should profit if the borrower successfully repays the loan.

But the NCLC says that in many cases installment loans allow the lender to profit even if the borrower fails to complete the repayment plan. This works well for the lender, but it can be a disaster for the borrower, who will then face perhaps irreparable problems with their credit. The misalignment incentivizes lenders to grant loans to customers who are unlikely to be able to repay them.

In the view of the NCLC, high-rate installment loans may therefore be as bad – or perhaps even worse – than payday loans. And this point of view appears to have found favor with the CFPB, which is also proposing to impose restrictions on some types of these loans.

In particular, lenders would not be permitted to offer refinancing to borrowers struggling to meet their payments unless they can demonstrate that such refinancing would materially improve the financial position of the borrower.

In addition, until November 2016, the CFPB is conducting an inquiry into various types of unsecured lending, including installment loans, seeking to gain information on pricing and underwriting practices. Its main concern is apparently to prevent borrowers being sucked into a long-term debt trap, a trap in which, even if they can manage the interest payments, the principal debt is never reduced.

It’s not clear how the CFPB’s request for information will play out, but it seems likely that properly structured installment loans are and will continue to be preferred (or at least less attacked) by the CFPB.

This article is for general informational purposes only. It is not professional financial or legal advice, may contain errors or be outdated due to recent developments, and may not relate directly to the products or services offered by this website.


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