Editor’s Note: On Friday, October 7th, the Consumer Financial Protection Bureau will close the public comment period on a rule to rein in payday loans. Please submit a comment to tell the CFPB why a strong rule to rein in the worst payday abuses is critical.
For seven straight years the United States’ economy has been in an expansion—one of the longest on record. Even better, data released earlier this month by the Census Bureau showed that middle class and low-income Americans have finally started to benefit.
Still, a huge number of Americans live paycheck to paycheck. Almost half of all Americans—a full 46%—say they would not be able to come up with $400 in the event of an emergency. Unfortunately, many will turn to payday loans to make ends meet.
What are payday loans?
Payday loans are advertised as quick and easy loans that borrowers can repay when their next paycheck comes around. There’s a catch, though. The interest rates are so high—often 400% and above, compared to about 16% on the average credit card—that borrowers simply cannot afford to pay back the loan and cover basic expenses at the same time. Instead, the vast majority of loans—80%—are rolled over or followed by an additional loan within just two weeks. The result is that borrowers wind up in debt—the median borrower for more than six months in a given year.
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Why do borrowers use them?
It’s fairly common knowledge that payday loans are a trap. So why do borrowers—let alone 12 million annually—even bother?
First of all, most payday loan borrowers—who are disproportionately people of color—have low or moderate incomes and struggle to obtain credit from mainstream sources like a credit card company or banks mostly because they have low credit scores. As a result, payday loans often appear to be the most accessible option.
Most of these borrowers take out payday loans cover everyday expenses (it’s a common misperception that payday loans are used as stop-gaps for unexpected financial setbacks). Since the cost of basic necessities, like rent and child care, has surged in recent years—at the same time that wages have stagnated—many low-income Americans have been left without an adequate and reliable cash flow.
How bad are they?
All told, the median borrower will pay $458 in fees on a typical $350 two-week payday loan. Many borrowers, however, will pay an even steeper price. Small payday loans often balloon into thousands of dollars in debt, and the effects of default are severe. If loans aren’t repaid quickly enough, payday lenders have the right to seize borrowers’ bank accounts to make sure that they are prioritized for payment above all other bills—no matter how urgent or essential. Borrowers can also end up saddled with insufficient fund fees from banks when lenders try to draw too much money from borrowers’ accounts. Even worse, an indebted borrower is more likely to have her bank account closed against her will, which pushes many consumers further out of the financial mainstream and forces them to use expensive alternative financial services—like check cashers and pawn shops—that carry higher fees and risk.
These problems affect entire families. Low-income families with access to payday loans are also more likely to struggle with bills like the mortgage, rent, and utilities. This can lead to foreclosure or eviction, which can devastate families in the short- and long-term. Payday loans are also linked with delinquency on child support payments, which deprives families of needed income and carries severe consequences for the parent unable to make payments, from a suspended drivers’ license to incarceration.
On some level, the entire nation is paying for this practice. Each year, payday loans drain more than $4 billion in interest and fees from the economy—and that’s just the direct cost. It doesn’t include the costs associated with homelessness (like emergency shelter) for families who lose their homes, or increased enrollment in public assistance programs to cope with the debt trap.
How can we protect borrowers?
State-level efforts to cap interest rates and fees to 36% or below—as 14 states and the District of Columbia have done—are key. But attempts to regulate predatory lenders otherwise have, by and large, proven to be exercises in futility. For example, after 64% of Ohio voters elected to ban the practice in 2008, loan sharks obtained licenses as mortgage lenders and continued to peddle payday loans under that guise. Predatory lenders in Texas acted similarly. In states where payday loans have been banned altogether, lenders have lured borrowers through online channels that can operate nationwide.
This “legislative Whack-a-Mole” at the state level has made it clear that the country needs federal reform to effectively protect borrowers.
Fortunately, the Consumer Financial Protection Bureau proposed new rules in June that target some of the most egregious practices in the industry. Under the new rules, loan sharks will have to determine whether prospective borrowers are actually able to repay a loan before they take one out (in most cases). The rules will also prohibit the repeated loans that trap borrowers in debt: Lenders will not be permitted to directly roll over loans or loan to those who seek to re-borrow within 30 days, unless those borrowers can prove that they will be in a better position financially. It will also place important limitations on lenders’ ability to seize borrowers’ bank accounts.
But here’s another idea: Eliminate the need altogether. If borrowers use payday loans to address chronic shortfalls, then economic insecurity has to be addressed as well through wage hikes and improvements to public assistance programs. These can go a long way to protect against cash shortages that lead families to take out loans with such insidious costs.