How New Rules Could Reshape The Payday Loan Industry

Wharton’s Jeremy Tobacman and Ohio State’s Creola Johnson discuss proposed changes to the rules governing payday loans.

The payday loan industry, long criticized for its predatory tactics targeting desperate consumers, is under new scrutiny by the federal government. The Consumer Financial Protection Bureau has proposed regulations to tighten several loopholes that are exploited by payday lenders and to curb some the issues with repayment of the loans.

In many cases, consumers are borrowing money against their paychecks and expected to pay back the loan within two weeks, along with a hefty interest payment. Jeremy Tobacman, a Wharton professor of business economics and public policy, and Creola Johnson, a law professor at The Ohio State University, take a look at the proposed changes and discuss whether they will have a lasting impact. They discussed the topic recently on the [email protected] show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

An edited transcript of the conversation follows.

[email protected]: What’s the most importance piece of these new rules?

Jeremy Tobacman: The central feature of the new rules is an ability to repay requirement. The typical model in the past for the industry has been to earn a lot of money off a sequence of finance charges. As a result, the underwriting procedures that they used were not geared towards trying to detect which borrowers would be likely to be able to repay the loans in full at their first due date.

Creola Johnson: There’s a section in the proposed rules that deals with attempts by payday lenders to change what they’re doing — what I call the chameleon. For example, in Ohio, a payday lending statute was passed to curb payday lending. Ohio has a Second Mortgage Loan Act that payday lenders got licenses to operate under. Most payday lending customers don’t own their home, but because Ohio law didn’t specifically require a mortgage under the Second Mortgage Loan Act, payday lenders started getting licenses to operate under that pre-existing law so that they could continue to issue triple-digit interest rate loans.

The Consumer Financial Protection Bureau’s new rule would then say any artifice, device, shenanigans to evade the rules, you would still be covered. In other words, the CFPB is saying we’re looking to the substance of what’s going on, not to some way that you’ve tweaked the transaction to try to pretend like you’re not issuing payday loans.

“Among the various payday lenders, some are trying to skirt the rules and some aren’t. Some are just trying to offer products that they think are useful.” –Jeremy Tobacman

[email protected]: The state rules versus what the federal government is talking about is an interesting point because there are 12 or 13 states that do have rules for payday lending.

Johnson: That’s correct. There are several states besides Ohio that have passed legislation to curb payday lending. So, for example, in Ohio, a payday loan interest rate is supposed to be capped at 28%. There are limits on how much can be lent, how often a person can obtain a loan. Yet what payday lenders started doing was creating contracts that created a longer long-term loan, so they could say, “Well, it’s not a payday loan because a long-term is more than two weeks. It’s not a payday loan because we’ve decided now we’re going to operate under this act.” Or there’s a current problem of what we call “rent to tribe.” That is payday lenders partnering with someone who lives on a Native American reservation, having an agreement to allow those loans to be technically issued from the reservation, so that the payday lender could argue that they don’t have to abide by the state law where the consumer resides. Again, this provision would deal with attempts to get around these new rules.

[email protected]: Obviously, these companies are looking at any way they can skirt the rules, whether at the federal or state level.

Tobacman: It’s certainly true that there are a variety of related products. There have also been a variety of illegal behaviors that have been subject to enforcement actions by the CFPB and the Department of Commerce. I think that among the various payday lenders, some are trying to skirt the rules and some aren’t. Some are just trying to offer products that they think are useful. One of the things that is impressive and sensible about the new rules that were issued is that the rules are designed to encompass many of these possible substitutes and to provide a clear, new framework for everything that might be an alternative to a payday loan.

[email protected]: The rules are also trying to address car title loans and high-interest installment loans, right?

Johnson: That’s correct. To get a car title loan, sometimes called auto title loan, the consumer has to own the car outright. So, if you’ve got a 2010 Ford Explorer that you’ve paid the loan off, you could take that car and go to a car title lender. They will lend you a fraction of the amount of what that car is worth. The car is worth $10,000; they will lend you $3,000. Then you have to pay that amount back usually by the end of 30 days. It doesn’t take a rocket scientist to figure out that that’s a lot of money to have to come up with in 30 days.

Payday lenders and car title lenders are considered cousins. That is to say, the transactions are similar in the sense that the consumer’s being asked to spend a large amount of money in a short period of time. And whatever you pay normally does not reduce the principal. For consumers who understand home mortgages, every month you make a payment there is so much interest and so much principal that is being paid. With car title loans and payday loans, if you pay an amount to extend the due date of the loan, that amount does not count towards reducing the principal that is owed.

That is problematic because people keep paying fees to extend the due date because they cannot pay that large amount of money in a short period of time. With car title lending, the CFPB has passed regulations to try to deal with that so that people can actually wind up with a loan they can pay back. The real problem with car title lending is that if you default and they can’t get you to come in and make a partial payment, they can repossess your car. Just imagine if you lost your transportation how difficult it would be to get to work and, therefore, keep a job.

[email protected]: Do you think these changes address enough of the problem, or is this just the first step?

Johnson: I don’t know if the CFPB is calling this a first step, but there are issues with payday lending that are not covered by these proposed rules. For example, payday lenders are notoriously known for threatening people with arrest if they defaulted on a loan. That’s because when payday loans first came on the scene, a person had to give a postdated check in return for getting the loan. You give them

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