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Will I be able to borrow $500 in a pinch if I need to?
Customers of payday lending companies may be wondering that following the release of the Consumer Financial Protection Bureau's long-awaited "payday lending rule."
The new regulation, announced this week, could significantly restrict lenders of short-term, very high-interest loans, known as payday loans. The practice has long been criticized by Consumers Union, the advocacy and mobilization division of Consumer Reports.
Consumers, in fact, may have better alternatives with community banks and credit unions. And experts say the CFPB's new rule could pave the way for even more lending by these types of financial institutions.
"This rule provides strong regulations to protect consumers," says Alex Horowitz, a senior research officer who studies small loans at Pew Charitable Trusts, a Washington, D.C., nonprofit think tank. "At the same time, it allows for banks and credit unions to develop lower-cost loans so consumers have a better option."
Rule Requires More Scrutiny of Borrowers
Payday loans are generally small—$500 or less—and typically come due in full by the borrower’s next paycheck, usually in two or four weeks. The loans have come under fire in recent years; studies show borrowers often end up stuck in debt cycles after taking out short-term loans with balloon payments at triple-digit APRs.
Among other restrictions, the CFPB rule requires lenders to determine up front whether borrowers have the ability to repay these loans and similar products. And lenders cannot give out more than three loans in succession to an individual.
Opponents say the changes could turn off a much-needed credit source.
"Millions of American consumers use small-dollar loans to manage budget shortfalls or unexpected expenses," said Dennis Shaul, CEO of the Community Financial Services Association of America, which represents payday lenders.
Others say the rule is a long overdue reform.
“The CFPB’s new rule will help consumers avoid getting trapped in a cycle of debt," said Suzanne Martindale, senior attorney for Consumers Union, the advocacy and mobilization division of Consumer Reports.
She notes that 15 states and the District of Columbia already have strong rate caps that prohibit high-cost payday loans. The CFPB's rule is the first-ever federal standard.
Credit Unions Could Fill the Void
The payday lending rule is set to take effect in July 2019, unless it is rolled back by Congress. The Congressional Review Act gives Congress 60 days from the time a new regulation is published in the Federal Register to rescind it.
Assuming the rule remains in effect, it's unclear whether the bulk of the payday industry could adapt. Some payday lenders are changing their practices already, creating less risky, longer-term loans.
Regardless, two types of consumer lenders that are exempt from the CFPB rule—community banks and credit unions—could step into the breach to serve payday loan clients.
Some credit unions already offer a loan called a "payday alternative loan," or PAL. The new CFPB rule exempts loans that meet PAL standards set by the National Credit Union Administration.
PAL interest rates cannot exceed 28 percent; combined with fees, the annual percentage rate cannot go above 36 percent. Loan amounts are between $200 and $1,000, and payback periods are shorter than six months. (One difference from payday loans: PAL loans are given only to borrowers who have been credit union members for 30 days or more.)
Banks Offer Another Option
The nation's nearly 6,000 community banks are another potential source for small loans. But community banks don't actively market their small-dollar loans, explains Lilly Thomas, a senior vice president and senior regulatory counsel for Independent Community Bankers of America, based in Washington, D.C. Rather, they respond to inquiries by individual customers.
"It really is an accommodation to their customers," she says. "Banks generally don't make money on these types of loans."
But, she added, the CFPB rule changes could change that.
"It may open up more ways to innovatively lend to members of the community," Thomas says.
A decision Thursday by Office of the Comptroller of the Currency also could lead the way for additional small-dollar lending by the nation's 1,356 nationally chartered banks and federal savings associations it regulates. By rolling back a 2013 rule, or "guidance," the OCC paved the way for many more lenders to make small-dollar, "advance deposit" loans to customers.
An OCC-regulated lender could, for instance, allow a regular customer who direct deposits a paycheck to get an advance on the amount of the paycheck, at a reasonable interest rate. (The decision doesn't cover banks overseen by the Federal Reserve or by state regulators.)
"The CFPB shut the door on a certain kind of loan, and the OCC now opens the door," notes Eric Compton, a regional bank analyst for Morningstar, an investment research company based in Chicago.
Consumer advocates, though, say the OCC's decision undermines the CFPB's rule. They say those deposit advances are another form of payday loans.
"CFPB research has shown that these loans bear similar risks to payday loans, and could cause substantial overdraft or non-sufficient fund fees," Consumer Union's Martindale says.
Will Every Consumer Be Served?
Even with innovation from banks and credit unions, Compton says he doubts that every payday customer will find a home with a new lender.
"There is some portion of the market where the legal rates that can be charged may not be enough to cover the lender's risks," he says.
But Horowitz says that the CFPB rule would make it possible even for people with low credit scores to get a loan of $500 or less at a bank or credit union. The key is to automate application processing, loan origination, and payment collection.
“Automating these processes minimizes the cost of offering these loans, and would allow banks and credit unions to earn a profit," Horowitz says. "And they'd charge borrowers prices six times less than they pay in the payday loan market today."
Consumer Reports is an independent, nonprofit organization that works side by side with consumers to create a fairer, safer, and healthier world. CR does not endorse products or services, and does not accept advertising. Copyright © 2017, Consumer Reports, Inc.