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The CFPB is shutting down a lot of payday loans — where will consumers go next?

MarketWatch logo MarketWatch 10/6/2017 Maria LaMagna
Many consumers who take out payday loans end up taking on more in the future. © Provided by Dow Jones & Company, Inc. Many consumers who take out payday loans end up taking on more in the future.

Is this the beginning of the end for payday loans?

The Consumer Financial Protection Bureau issued a final version of its rules for payday lending on Thursday. “The CFPB’s new rule puts a stop to the payday debt traps that have plagued communities across the country,” said CFPB Director Richard Cordray. “Too often, borrowers who need quick cash end up trapped in loans they can’t afford.”

The CFPB issued the rule after researching payday lending practices for five years; it published a proposed rule in June 2016, which received more than one million comments online and was revised to its current format.

The goal: To break a “cycle of taking on new debt to pay back old debt,” the CFPB wrote.

It will regulate loans that require consumers to repay all or most of their debt at once, including payday loans, auto-title loans and “deposit advance” products, which typically work by taking the repayment amount out of the borrower’s next direct electronic deposit.

Some 12 million Americans take out payday loans each year, according to the nonprofit Pew Charitable Trusts, a nonprofit based in Philadelphia. But those consumers also spend $9 billion on loan fees, according to Pew: The average payday loan borrower is in debt for five months of the year and spends an average of $520 in fees to repeatedly borrow $375. (And they don’t help borrowers build credit, unlike some other options.)

Almost 70% of payday loan borrowers take out a second loan within a month of their last one, according to CFPB research. Although some have praised the rule, others have pushed back and said consumers will have fewer options when they are in tight financial situations.

Here’s what the new rule will mean:

The new rule outlines new restrictions on payday loans

There are some 16,000 payday lending stores in 35 states that allow payday lending, the CFPB said. Because of certain state laws, payday lending is already effectively illegal in 15 states.

The new rule requires lenders to do a “full-payment test” to determine whether the borrower can make loan payments. To complete that test, the prospective borrower would have to show proof of income.

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It also limits the number of loans consumers are able to get; they can only get three loans “in quick succession.” Lenders will be required to use credit reporting systems registered by the CFPB to report and get information about those loans.

There are certain conditions under which borrowers are exempt from some of these rules.

Consumers are allowed to take a short-term loan of up to $500 without doing the full-payment test, if the loan is structured for the borrower to make payments gradually. This is known as the “principal-payoff option.” But those loans cannot be given to borrowers who have recent or outstanding short-term or balloon-payment loans.

Loans the CFPB believes “pose less risk” to consumers don’t require the full-payment test, nor do they need the “principal-payoff option.” Those that “pose less risk” include loans from lenders who make 2,500 or fewer covered short-term or balloon-payment loans per year and derive no more than 10% of revenue from those loans. Those typically are small personal loans from community banks or credit unions, the CFPB said.

After two straight unsuccessful attempts, the lender cannot debit the account again without getting new authorization from the borrower.

The reaction to the new rule

Some consumer advocates praised the new rule.

“Today’s CFPB action is a major step toward ending predatory practices that lead borrowers to disaster,” said Joe Valenti, the director of consumer finance at the Center for American Progress, a left-leaning public policy organization based in Washington, D.C., in a statement.

The final version of the rule is “a major improvement over the proposal” the CFPB originally developed, said Alex Horowitz, a senior research officer for The Pew Charitable Trusts. “It’s tailored to cover the most harmful loans while continuing to allow consumers access to credit.”

But Dennis Shaul, the CEO of the Community Financial Services Association of America, a trade group that represents nonbank lenders, called the rule “a tremendous blow to the more than one million Americans who spoke out against it.”

Where desperate consumers will go instead of payday loans

Richard Hunt, the president and CEO of the Consumer Bankers Association, a trade group for retail banks, said the rule could drive needy consumers to other poor alternatives, including pawnshops, offshore lenders, high-cost installment lenders or unreliable “fly-by-night” lenders.

But Brian Shearer, an attorney-adviser for the CFPB, said the bureau has researched the states where payday lending is illegal and has determined this should not be a significant worry.

Horowitz of Pew Charitable Trusts said banks and credit unions will likely increase their small-dollar loan offerings, if “regulators let them,” which could save borrowers money, versus what they paid to borrow payday loans.

Banks are “eager to expand their offerings of trusted and responsible services to these borrowers,” said Virginia O’Neill, the senior vice president of the center for regulatory compliance at the American Bankers Association, a trade group.

How the rule will be enforced

State regulators will enforce the CFPB’s new rule, if it becomes effective, along with the CFPB.

The final version of the CFPB rule must be published in the Federal Register, a government publication. Once it is, it will take effect 21 months later. But according to the Congressional Review Act, Congress can pass a joint resolution disapproving the rule, which would prevent it from taking effect.

“Congress should not side with payday lenders on this,” Horowitz said. “If Congress is going to play a role here, they should tell bank and credit union regulators to provide guidelines for small installment loans. They should not overturn this rule.”

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