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 Knowledge@Wharton 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.
Knowledge@Wharton: 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
Knowledge@Wharton: 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.
Knowledge@Wharton: 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.
Knowledge@Wharton: 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.
Knowledge@Wharton: 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 a postdated check for $350, they give you $300 cash, and in two weeks you’re supposed to come back and pay the $350. If you don’t pay it, the check gets dishonored. What was happening was that payday lenders were threatening people and filing criminal complaints to have people arrested for passing a bad check. Over time, a lot of actual arrests went down.
“Just imagine if you lost your transportation how difficult it would be to get to work and, therefore, keep a job.” –Creola Johnson
It has come to light in the last three, four years that some payday lenders, particularly in Texas, were still getting people arrested by filing criminal complaints with the local district attorney that they had passed a bad check. The rules don’t specifically get into dealing with this issue of threatening people with arrests, and that’s really problematic because a lot of people are paying debts they don’t even owe or debts that they have paid off because of the threats of arrest. Payday lenders are often able to extract a lot more money out of them because of that.
An enforcement action was brought by the CFPB a couple years ago against Ace Cash Express, which is the second-largest payday lender in the United States. One of the allegations against them was threatening people with arrest, having people fear being arrested to get them to pay amounts they didn’t owe or get them to pay amounts in excess of what they owed.
Tobacman: I’ll say that I think the new rules have been carefully crafted in the sense that the CFPB has done a lot of very careful data analysis to document the patterns. They have tried to collect extensive information from consumer groups, from industry and from other people working in this area, including the research community. I think that this imposition of the ability to repay underwriting standard is one that is easily articulated and relatively easily to implement by the lenders that choose to try to keep operating it. That simplicity is probably deliberate on the CFPB’s side. It’s also a pretty straightforward step from the central finding in CFPB’s empirical work, that the fault rates are incredibly high on all of the covered products addressed by this regulation.
The high default rates have all of these consequences, including collections, behavior, which is at the very least problematic for the delinquent borrowers and often times illegal in the sense of violating the Fair Debt Collection Practices Act. There are all these other follow-ons that tend to be commonly associated with these types of products, especially when the loans become delinquent. One way to reduce the harms to consumers associated with those follow-on behaviors by the lenders and collection agencies is by imposing this new standard that the loans can’t be made unless there’s an expectation that the borrowers will be able to repay. In that sense, I think it’s very deliberately crafted.
Knowledge@Wharton: What are some of the states where this is a significant problem that needs to be addressed immediately?
Johnson: In 2006, Congress passed the Military Lending Act to deal with payday loans, rent-to-own transactions and other credit transactions considered problematic for people in the military. With respect to payday loans, they capped the interest rate to active duty military personnel at 36% and did some other things to try to curb it.
What happened after that was payday lenders were just basically tweaking what they did to get around the Military Lending Act. They would make the loan term longer, make the finance amount different. In 2015, the Department of Defense expanded the definition of what we call payday loans so that we could try to curb it. The payday loan rules under the Military Lending Act, however, don’t go into effect until October 2016. Right now, we don’t know what the payday lenders are going to do in response to this to see if these new rules by the Department of Defense will actually make the loans that are being issued to military personnel comply with these new regulations.
In Arizona, payday lending was effectively prohibited by statewide referendum in 2015. Yet you’ve got regulators finding out that they have done things to get around that. For example, instead of calling them payday loans, they’ll call them installment loans or something else. Virginia is another place. In 2009, they amended their payday lending act, adding a 45-day cooling off period between when you can get the next loan.
“Payday lenders are notoriously known for threatening people with arrest if they defaulted on a loan.” –Creola Johnson
Part of what I would like to see is a national database. I know when we hear database, it’s like, Uncle Sam is watching you. But if you think about it, if you say the consumer is not supposed to be able to get so many loans within a year, then how can you track if that’s happening? It’s only through a database you can figure out if payday lenders are complying because they would have to submit the names or account numbers of folks who are getting the loans.
One of the things that has not gotten enough media attention is that there’s a carve-out for credit unions that give these payday alternative loans. They’re called PALS, payday alternative loans. I don’t want people to listen to the mantra of the industry saying, “If you do this, then there won’t be any short-term affordable loans to consumers.” That is not the case. Two national credit union associations have supported and pushed for the CFPB to do a carve-out. They wanted a carve-out for credit unions in general, but that’s not what the CFPB did. Instead, there’s a carve-out for these payday alternative loans.
Notably, these loans have an interest rate capped at 28%, application fees cannot be greater than $20. There can’t be more than three PALS within a six-month period. This is a good thing because this is the chance for the credit unions to have the opportunity to go out and market these PALS in a way that consumers will realize that they still have access to more affordable short-term credit.
Knowledge@Wharton: What do you think is the impact on the industry with these specific changes the CFPB is bringing forward?
Tobacman: I think there’s a consensus that lots of payday lenders are going to exit if this rule goes into force. I haven’t heard a dissenting comment from that view. But there’s also a question about what structure the lenders have now. Over the last decade, we’ve seen an enormous portion of the payday lending business go online. If somebody is running an online payday lender now, then probably they’ve paid a lot of fixed costs in order to get their algorithms set up. They might still be able to keep going, just at lower volumes and tighter underwriting standards. In terms of the number of operators, my guess is that we might not see that big a reduction online. In terms of the bricks-and-mortar stores that have higher marginal costs of staying in business and continuing to operate, I bet a lot of them are going to close.
Johnson: I’m not so sure that’s true. The national Consumer Law Center has come out with a step-by-step of the loopholes they think still exist within these new rules. For example, the rules say you’re supposed to assess the ability of the borrower to repay — but that’s not all loans. There are certain loans where, if you meet certain requirements, the payday lender doesn’t have to do an assessment of the person’s ability to repay. And that’s problematic if you think about the CFPB research that has found consumers tend to be overly optimistic about good things happening to them and minimizing bad things happening to them.
Knowledge@Wharton: Part of this would also go to the changes that the CFPB is trying to bring forward, the fact that some states have rules in place and whether we will see a continued push to protect the consumer and maybe even have tougher rules down the road.
Tobacman: It’s not impossible. The CFPB has been working on these rules for a long time and my guess is that they are unlikely to revisit the issue after the final rule is rolled out in the near future. There’s also certainly a question about what may change in Washington after this November.
Johnson: It’s possible that they could revisit. Assuming that the election results are lined up with an action plan to hobble the CFPB, which there have been numerous bills over the last few years to try to limit the CFPB’s authority. If that doesn’t happen, then the CFPB can do just like the Department of Defense has done. It’s been 10 years since the Military Lending Act was passed by Congress, and last year the Department of Defense said, “OK, now that we see the loopholes and how they’ve figure how to get around those, we’ve got these new rules.”
I think the CFPB has been very good at doing research and documenting data. If a few years from now we see that their loophole is actually being exploited to get around these payday lending rules, then I think that we can expect the CFPB to close those loopholes. What they’re thinking now is they’ve come up with a strong set of rules that they think may work. And remember, we’ve got that carve-out for PALS. Therefore, if there’s no need to tighten the rules further because we’ve got this push towards consumers getting PALS, then we have consumers doing what we want all along, which is to seek out and obtain loans that are safer.
Knowledge@Wharton: When is the expectation that these rules would be put in place?
Tobacman: I think the comment period ends September 14 and then the comments get reviewed. I don’t know exactly the time frame after that.
Johnson: I would imagine that the new rules will not go into effect until 2017.