As the recovery from the recession slowly continues, many struggling households may find themselves without the resources to cover necessary expenditures. Some of these households turn to small- dollar loans like payday lending to meet their immediate needs. But these loans are only beneficial if the borrower is able to repay the loans at reasonable cost. A new report from the Center for Economic and Policy Research argues that there are two aspects to the small-dollar loan problem in the United States — substantial unmet demand for high-quality, small-dollar loans and a too great a supply of ultra-high-cost loans that do far more harm than good to borrowers.
The report, “Small-Dollar Lending,” provides an overview of the current small-dollar loan industry and the regulations currently in place as well as proposed legislation currently being considered in Congress.
“The great majority of the twelve million Americans who obtain payday loans each year – at an average of eight loans each – would be better off receiving no loans at all. Public policy should help these households identify genuinely helpful alternative ways to address their financial problems,” said Jim Campen, the author of the paper.
The banking industry and consumer advocates have established four criteria for identifying high-quality small-dollar loans: an APR of no more than 36 percent; a loan repayment term of at least 90 days; repayment in installments rather than a single lump sum; and an assessment by the lender of the borrower’s ability to repay the loan. But with just over one quarter of all U.S. households lacking access to traditional lines of consumer credit, the number of borrowers far outstrips the supply of these higher-quality loans. As a consequence, millions of consumers end up with payday-type loans that can charge APRs of 390 to 520 percent, and are due in a lump sum in a matter of weeks. For a typical loan of $350, a borrower would pay $409.15 just two weeks after receiving the loan. Often this creates a “debt trap” when the borrower’s inability to repay the initial loan leads to the need to take out another loan to pay off the first. Research indicates that over three-quarters of all payday lopans are made within two weeks of the due date of a previous loan. And payday lenders rake in $7 billion in fees from borrowers annually.
While these loans make up the vast majority of small-dollar loans, there is a pool of high-quality loans that are affordable and welfare-enhancing for the borrower (and economically sustainable for lenders). Expanding this pool of loans is one means of reducing more harmful loans. A better regulatory regime is another. The Consumer Financial Protection Bureau (CFPB), established by the Dodd-Frank Act, has great potential to reduce the extent to which consumers are hurt by high-cost small-dollar loans via greater federal supervision for compliance with federal laws and regulations. Regrettably, current proposed legislation, particularly the “Consumer Credit Access, Innovation and Modernization Act” falls short and actually paves the way for introducing payday-type loans into states that currently prohibit them. The loans created under this legislation would not meet the above criteria for a high-quality small-dollar loan.
The report suggests that there are ways for policy makers, responsible lenders, interested non-profits organizations and others to help consumers meet their needs in times of financial distress and deal with the problem of small-dollar loans. They can try to ensure that the supply of high-quality loans is increased, encourage initiatives that that work to reduce the reliance on small-dollar loans such as increased savings and other forms of asset building, and support initiatives by the CFPB that seek to eliminate abusive features and practices at all stages of the loan cycle.
The full report can be found here.