Last week, the Consumer Financial Protection Bureau, the federal watchdog agency charged with protecting Americans from financial exploitation, proposed long-awaited new regulations on the payday lending industry. Under the new regulations, payday lenders would be required to verify an applicant’s ability to re-pay a loan without re-borrowing at the end of the loan period. The proposed regulations take aim at a particularly devastating payday lending practice. While the rates charged on a standard two-week payday loan are painfully high (although, on an annualized percentage basis, they’re lower than the overdraft fees charged by banks), the real problems often begin when borrowers are unable to pay back the loan at the end of the two-week period and take out another loan, with additional fees. Under the proposed regulations, lenders will be limited in the number of times they can roll over a loan.
In a statement accompanying the new regulations, Richard Cordray, the director of the CFPB, explained the scale of the re-borrowing problem:
Approximately one-in-four new loans results in a sequence of at least ten loans, one after the other, made in a desperate struggle to keep up with the payments due. Each time, the consumer pays more fees and interest on the same debt, turning a short-term loan into a long-term debt trap. It is much like getting into a taxi just to ride across town and finding yourself stuck in a ruinously expensive cross-country journey.
Indeed, the very economics of the payday lending business model depend on a substantial percentage of borrowers being unable to repay the loan and borrowing again and again at high interest rates, incurring repeated fees as they go along. More than half of all payday loans are made to borrowers in loan sequences of ten loans or more. For borrowers who are paid weekly or bi-weekly, one-fifth of these loans are in sequences of 20 loans or more.
The proposed regulations have been met with mixed reactions. Payday lenders, naturally, say the rules will destroy the industry, and the CFPB itself estimates that the regulations could cause loan volume to fall by 55 to 62 percent. Consumer advocates, meanwhile, argue that the proposed rules don’t go far enough. “Pew’s research shows that borrowers want three things: lower prices, manageable installment payments, and quick loan approval,” Nick Bourke, the director of Pew Charitable Trust’s small-dollar loans program, said in a statement. “The CFPB proposal goes 0 for 3. The rule will help by pushing lenders to make installment loans instead of requiring full payment at the next payday. That will represent a major improvement, but it is not enough to make these loans safe. A $400 payday installment loan, for example, will still cost a typical borrower more than $350 in fees.”
Of course, the CFPB’s proposals don’t do much to address the underlying demand for payday loans. People take out payday loans because they need money, and they need it fast. A recent Federal Reserve Board survey found that 46 percent of American adults would “struggle to meet emergency expenses of $400.” Banks, meanwhile, have largely gotten out of the business of making small loans, particularly to low-income borrowers with less-than-stellar credit. Payday lenders argue that they’re not unscrupulous predators, but are simply providing much-needed credit to a group of Americans who can’t get it anywhere else and have little savings to fall back on.
Banks have largely gotten out of the business of making small loans, particularly to low-income borrowers with less-than-stellar credit.
So which is it? A 2009 working paper by the economists Marianne Bertrand and Adair Morse sheds some light on this question. As part of a randomized field experiment at a national payday lender, the economists divided borrowers into four groups, providing each group with a different intervention meant to test whether borrowers truly understand the terms of their payday loans.
The first group received a more in-depth description of the annualized percentage rate (APR) of a payday loan. While payday lenders are required to inform borrowers of a loan’s APR, they often present the fees in dollar terms, i.e. a $100 payday loan incurs fees of $15. Bertrand and Morse hypothesized that such a presentation was confusing for unsophisticated borrowers; they instead disclosed the APR “in contrast with other consumer finance rates that people are familiar with paying — car loan, credit card and subprime mortgage APRs.”
A second group of borrowers received information about the cumulative effect of payday loan fees, to test the theory that borrowers might fail to consider how the fees for such loans add up when they’re repeatedly rolled over.
A third group received information about how long it takes the typical borrower to re-pay their loan (i.e. how many times they roll the loan over). This treatment was mean to challenge borrowers’ overly optimistic assumptions about re-payment. A final group of borrowers received a savings planner. The economists then tracked post-intervention borrowing behavior.
Interestingly, the first group of borrowers—those who received more contextualized information about APRs—didn’t change their subsequent borrowing behavior; neither did the group of borrowers who received the savings planner. But the group of borrowers who received information about the cumulative effect of payday loans were 10 percent less likely to borrow from a payday lender after the intervention. Borrowers who received information about the typical re-payment profile also borrowed less in subsequent pay cycles. “The near 10 percent reduction in borrowing we observe should be cast in the light of the relative ease and low overall cost of implementing the improved disclosure,” Bertrand and Morse write. “However, those convinced that close to all payday borrowing is irrational may argue that 10 percent is a disappointing effect. Most likely, payday borrowing is a mixture reflecting both irrational and rational decisions.”
It’s well-documented that payday loans can have tragic financial consequences for low-income Americans — regulating the industry is a good first step. But the real tragedy of the payday lending industry, and the alternative financial services industry in general, is that so many Americans have no other option.
