This week, America’s consumer watchdog put into place a new rule that will effectively kill the businesses of many payday lenders, companies that issue short-term, high-interest loans.
The rule from the Consumer Financial Protection Bureau requires payday lenders to determine whether they are likely to be paid back — before a loan is issued. CFPB research found that the 16,000 payday loan stores make their money on people who cannot pay back the loan at the end of the period — typically two weeks.
“These protections bring needed reform to a market where far too often lenders have succeeded by setting up borrowers to fail,” CFPB director Richard Cordray said on a call to reporters. “The principle that lenders must actually evaluate the borrower’s chances of success before making a loan is just plain common sense.”
Given that payday lenders make the bulk of their money due from loans that are not paid quickly, this will likely put many lenders out of business, leaving a gap in service for people looking for small short-term loans. That is, until the new players like credit unions and fintech apps fill the vacuum.
What are low-income consumers going to do if they need money?
Attacking the business model — terrible or not — will probably cripple much of the industry, as the rule kills the profit center. The industry gets around $7 billion in fees every year from 12 million borrowers. But while this will make it more difficult for people to get drawn into a riptide of endless debt, it will also make it far more difficult for people in a pinch to raise needed money.
“The CFPB’s misguided rule will only serve to cut off their access to vital credit when they need it the most,” said Dennis Shaul, CEO of the Community Financial Services Administration of America, a payday loan interest group in a press release.
This point is debatable, and Cordray’s remarks pushed back on this idea. “If a borrower living paycheck to paycheck needs a payday loan to cover basic expenses or to recover from a large expense or drop in income, they will probably face the same cash shortfall when they get their next paycheck,” he said. “Only now, they have the added cost of loan fees or interest.”
Alternative solutions may be able to square the circle by providing this needed credit at a cost that isn’t catastrophic. The CFPB’s finalized rule differed from its previous rule by exempting businesses whose model doesn’t rely on these extremely high-interest loans. Companies that issue fewer than 2,500 of these loans and make less than 10% of revenue from these loans can continue to do their thing.
Credit unions and banks may see an opportunity
On the call to reporters, Cordray said that the bureau has “no intention of disrupting lending by community banks and credit unions. They have found effective ways to make small-dollar loans that consumers are able to repay without high rates of failure.” The credit union industry welcomed the narrowing of the rule to exclude their activities, and the praise.
“The rule will allow those who already offer payday alternative loan programs to double down,” a spokesperson for the National Association for Federally-insured Credit Unions told Yahoo Finance. “For credit unions not offering programs, the rule gives them an avenue to develop a program and take best practices from those who are already doing it well.”
The CFPB isn’t the only agency pushing for credit unions to take a larger role in filling the vacuum that these payday lenders will doubtless leave. The Office of the Comptroller of Currency also is emboldening credit agencies to get involved. The day the rule was announced, the OCC acting comptroller Keith A. Noreika rescinded guidance on deposit advance products to help banks and credit unions offer responsible small-dollar lending.
“The OCC continues to encourage national banks and federal savings associations (collectively, banks) to offer responsible products that meet the short-term, small-dollar credit needs of consumers,” the agency said in a press release.
Big data and apps
Besides credit unions and banks, other services are emerging such as Activehours, a free service that allows you to withdraw money the day you earn it instead of waiting until payday. Using technology made possible by online banking, the service can integrate with your bank activity to see that you’re gainfully employed, making a quick judgement to confirm that you will, in fact, make the money by next paycheck.
This ability to quickly make quick credit decisions efficiently and cost-effectively is far more likely in today’s age of data science and rapidly evolving technology, leaving a strong opportunity for fintech to innovate. For financial institutions like banks and credit unions or new apps, these tools could prove to be essential in making their activities scalable and, thus, feasible as a service to offer consumers.
In the next chapter of short-term loans, this scale may turn out to be a pivotal part, and is something that is made easier without competing with 16,000 incumbent payday lenders with large neon signs. Without high interest rates, scale and efficiency may be the only way for these alternatives to fully develop into something that can flourish. For now, however, a large gap will likely remain between those who are looking for a quick loan and those who can provide them.