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The Consumer Financial Protection Bureau proposed a new rule on Thursday that would require lenders to verify that borrowers can afford to pay back high-cost advances like payday loans and those that use cars as collateral. Specifically, lenders must verify borrowers’ income and check their other financial obligations, including rent, child support, and student loans.
The consumer protection agency is stepping in to regulate the $38 billion payday and auto title loan industry, which has been controlled r state-by-state. Currently, about 16,000 payday loan stores operate in 36 states, according to the CFPB.
The agency’s proposed rule would cover both short-term loans with repayment terms under 45 days, and longer loans with interest rates that exceed 36% and give the lender the right to seize a vehicle held as collateral, access a borrower’s checking account, or garnish their wages. The CFPB noted general auto loans, home mortgages, student loans, credit cards, and pawnshop agreements are not covered under the proposal.
The rule also would label it an “unfair and abusive practice” for lenders to attempt to withdraw multiple payments from a consumer’s account when previous attempts have failed. This common practice can rack up overdraft fees for borrowers and make it even harder to pay back the balance of the loan.
Specifically, CFPB says the new proposed rule is designed to protect consumers from falling into “debt traps” while using these loans, which typically have very high interest rates—the annual equivalent of 390% or more for a two-week loan.
“These strong, common-sense protections would apply mainstream lending principles to payday, auto title, and certain other high-cost installment and open-end loans,” CFPB Director Richard Cordray said Thursday.
About 12 million Americans take out these types of high-cost loans every year, according to research from Pew Charitable Trust. Those harmed by these predatory lending tactics tend to have incomes under $40,000. The majority of payday borrowers are white females aged 24 to 44.
In fact, 42% of millennials have used a payday loan, auto title loan, or another alternative financial product in the past five years, according to a 2015 survey by PricewaterhouseCoopers and the Global Financial Literacy Excellence Center at George Washington University.
The average payday loan is about $375, according to Pew’s research. And while these loans are advertised as short-term, emergency funds, it generally takes borrowers five months and $520 in fees to pay them off.
“Too many borrowers seeking a short-term cash fix are saddled with loans they cannot afford and sink into long-term debt. It’s much like getting into a taxi just to ride across town and finding yourself stuck in a ruinously expensive cross-country journey,” Cordray said.
The CFPB found similar problems with single-payment auto title loans, which are also included in the scope of the rule. For these loans, borrows put up their vehicle as collateral, promising to pay back the lump sum, interest, and fees within a short time period, usually about 30 days.
But again, the high interest rates (generally 300%) mean people often struggle to meet the terms of the loan. One in five borrowers has their car or truck seized for failing to repay the loan, the CFPB found in its analysis.
“The CFPB is proposing sweeping changes to an industry that, for decades, has trapped millions of consumers seeking short-term credit in a long-term cycle of debt,” says Tom Feltner, director of financial services at the Consumer Federation of America.
But while Feltner says borrowers will be better protected, he believes further changes are necessary to eliminate the harmful effects of triple-digit interest rates and coercive collection practices. Specifically, the CFA contends the final rule should require lenders to fully consider a borrower’s ability to repay all loans without exception. Currently, the proposed rule would allow lenders to make up to six loans per year without considering a borrower’s ability.
“Even one unaffordable loan can cause long-term financial hardship,” Feltner says. “This concerning exemption to the general ability to repay requirement should be removed in the final rule.”
The agency is seeking comments on the rule through Sept. 14, 2016. After, the agency is aiming to have the rule go into effect 15 months after a finalized version is publicly released.