Novelist and essayist James Baldwin once wrote, “Anyone who has ever struggled with poverty knows how extremely expensive it is to be poor.” These words ring true for those that have relied on payday loans to satisfy immediate needs, be it food, rent or utilities. A quick loan of a small sum of 300 dollars at exorbitant rates of interest can set a low-income family on the path of financial distress. What started as a loan to tide them over until the next paycheck can quickly turn into a debt trap, as they struggle to keep up with mounting debts.
The Consumer Financial Protection Bureau (CFPB) is trying to make poverty a little less expensive by attacking payday lending head on.
The CFPB’s payday loan ruling’s comment period is set to close this Friday. According to its authority established under the Dodd-Frank Wall-Street Reform and Consumer Protection Act, the CFPB is proposing “12 CFR Part 1041,” a rule that would regulate consumer credit loans with terms of forty-five days or less. The rule would also cover loans with repayment terms greater than forty-five days if they have an annual rate of interest greater than 36 percent and are repaid directly from the consumer’s income or are secured through the consumer’s vehicle.
Payday lenders are knowingly profiteering off of the financially vulnerable.
These conditions would make the rule applicable to payday loans, auto title loans, and other high-cost installment loans. Each of these loans are currently difficult to pay back and cater to low-income people who are struggling to make ends meet. Designed to tide people’s expenses over until payday, payday loans are short-term loans with high interest that are designed to be paid back once a borrower receives their next paycheck. With annual percentage rates of up to 400 percent common for payday loans, they are exceedingly difficult to pay back for low-income workers with little income and precarious work hours. Payday lenders are knowingly profiteering off of the financially vulnerable, which is especially detrimental for low-income people of color who are struggling to build household wealth.
As it stands, the rule would regulate these lenders by requiring them to “reasonably determine that the consumer has the ability to repay the loan.” The rule would also require increased information provided to consumers and would place restrictions on lenders withdrawing money directly from borrowers’ accounts if two previous payments have failed.
Financial protection groups around the country are submitting suggestions to the bureau to maximize the rule’s effectiveness in regulating the payday loan industry. With high interest rates that take advantage of low-income people struggling to make ends meet on a paycheck-to-paycheck basis, this rule has the capacity to end exploitative lending to low-income households, a move that could relieve these households of financial stress and point the way to financial stability for working families.
The Debt Trap: A Critique of Payday Lending
Auto-title loans are loans lent at high interest to consumers with a car title listed in their name. They temporarily forfeit their title to the car as collateral for the money they are borrowing. This can lead to repossessions if a borrower is unable to pay back the loan.
Our focus here is on payday loans, since auto-title lenders exhibit similar predatory tendencies with the added dimension of collateral in the form of a vehicle.
Also known as a cash-advance loan, a borrower forward-dates a check to the payday lender in the amount of money they need from that lender, plus a fee. The borrower is then lent the money on the condition that the lender can cash the forwarded check on an agreed upon date (usually the borrower’s payday). In this arrangement, your paycheck is both your collateral for the loan and the means of payment for the loan.
What sounds like a reasonable financial arrangement on the surface is in reality a debt trap. The fees associated with borrowing money before payday to meet immediate expenses are nothing short of exorbitant.
What sounds like a reasonable financial arrangement on the surface is in reality a debt trap. The fees associated with borrowing money before payday to meet immediate expenses are nothing short of exorbitant. Even if the rate seems fair, say $10 per $100 borrowed at a seven day advance, that translates into an annual percentage rate of interest of 520 percent.
In practice, a borrower takes out an initial payday loan to meet immediate expenses (a car repair, groceries, childcare, etc.) that cannot wait until payday. They use it to defray expenses in the immediate term, but find that it becomes more difficult to defray expenses in the long term when a payday lender is gouging a part of their paycheck for a high fee. They return to the lender again to borrow more because their last paycheck was too small (after the lender withdrew fees for the initial loan) to afford much of anything. This process continues until the borrower cannot pay the loans back in full, in which case they get a rollover of the debt for still another fee.
Before long, the borrower is ensnared in the debt trap, struggling through financial stress.
Looking at the Data on Payday Loans
Financial stress has been a feature of American working class life for some time now. This fact is even more evident among individuals that resort to short-term lending to meet their immediate economic needs. The Federal Reserve’s Survey of Consumer Finances (SCF) is a triennial survey that collects detailed information about the balance sheets of American households. Since 2007, the survey has asked respondents if they have taken out a payday loan within the last year. Results around this question demonstrate the precarious situation that those with payday loans can find themselves in, as debt traps loom.
Figure 1 demonstrates that, relative to wealthier households, a higher percentage of working class families have had to take out a payday loan in the past year. Working class families here are defined as a household that works for someone else, has no capital income, and earns annual wages less than $66,000 (the weighted 60th percentile of the 1992–2013 SCF dataset).
Table 1 demonstrates that a vast majority of those with payday loans are financially stressed relative to households without payday loans; median household wage income is also far lower for those with payday loans. Financial stress is constructed here by the author as a 0–1 variable based on financial stress variables in the SCF. A household is financially stressed if they are late on payments, filed for bankruptcy in the past five years, have been turned down for credit in the last year, or fear being turned down for credit.
|Table 1. Selected Characteristics of Households with Payday Loans
||Median Annual Wage ($ 2013)
|No Payday Loan in Past Year
|Had a Payday Loan in Past Year
|Source: Author’s Calculations using weighted SCF data.
Those with payday loans earn far less income and are financially stressed. A strong CFPB rule is necessary to counter this development.
How to Regulate to Do Away with Payday Lending
With these levels of financial stress facing households with payday loans, bolder rulemaking will be needed to protect working families. Consumer protection groups’ comments on the proposed rule stress the need to end payday loans and auto title loans for good. National groups and New York organizations have sign-on letters to urge the CFPB to strengthen the proposed rule. These groups want to make it easier to:
- federally enforce state regulations that restrict payday lending
- close loopholes in the rule that could allow payday lenders to subvert state regulation
- strengthen the “ability to pay” requirement in the proposed rule by including income and expenses in the calculation of said “ability to pay.”
There need to be alternatives to this kind of financial exploitation. Expanding banking access to low-income people would also be beneficial; proposals like housing savings accounts in post offices could be sensible solutions for the underbanked working poor. Credit unions can also cater to low-income workers in a sustainable, community-oriented way. Regulations that prevent predatory lending with other forms of credit while still allowing lenders to factor in risk would aid the underbanked.
They can also be found in policies designed to reduce the costs of expenses that force people to resort to payday lending in the first place. Bolstering the social safety net, increasing food stamps, bettering pay for low-income workers, establishing universal child allowances, and reducing inequality through worker cooperatives are all a variety of medium to long-term proposals that would make working families feel more financially secure. The ultimate solution, however, would be to have people earn living wages.
Simply put, there is such a wide variety of alternatives that can replace high cost borrowing like auto title loans and payday loans. Tomorrow’s CFPB rule would benefit from more stringent regulations on payday lending. If done right, this could make payday lending a thing of the past. And at that point, energy could be devoted to helping low-income workers enhance their living standards by improving their access to fair lending, bolstering social programs, and empowering workers.