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Payday loans: Can Washington make them less predatory?

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Payday loans charge huge interest but can be useful for some borrowers in a pinch. The federal government is stepping in with new rules aimed at protecting the most vulnerable. 

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    Gilbert Walker, a retired school district employee, stands outside the Payday Loan Store in downtown Chicago after paying off the last $165 of a $600 loan. He has used payday loans only a few times for an emergency, like a heating bill, or for a little something extra at Christmas.
    Jeremy Borden
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As one of Chicago’s elevated trains clatters overhead, Gilbert Walker strides into the Payday Loan Store to make his final $165 payment on a $600 loan he’d taken out at Christmas.

The interest rate was high. Mr. Walker, who had been laid off after more than 30 years with the Chicago school district, couldn’t remember how much he’d repaid so far. Still, it beat paying the bank an overdraft fee and was quick and easy to obtain for an emergency, like a big heating bill, that his $2,000-a-month pension can’t quite cover.

“It’s much cheaper than the bank,” he says. “It would be tough” if the stores went away.

But that is precisely the prospect that lies ahead under new federal rules proposed Thursday. The payday loan industry is facing a dramatic consolidation. 

The goal is to curb predatory lending. Payday loan stores charge annualized rates of 400 percent or more for short-term loans, and many states have stepped in to cap the rates the stores can charge.

But instead of capping interest rates, the new set of proposed rules by the Consumer Financial Protection Bureau (CFPB) aims to strike a balance, allowing payday lenders to continue making loans but only to people who have the wherewithal to pay them back.

“Payday lending will still exist after this proposal,” says Alex Horowitz, a researcher on small loans at the Pew Charitable Trusts. Nor will the rates they charge necessarily fall, he and other experts say, since the CFPB has no power to cap rates.

Rather, some people who want payday loans simply won't be able to get them anymore.

For many Americans, this is no small thing. Behind the rapid growth in payday lending since the 1990s lies nagging financial insecurity for many families – one sign of stagnant wage growth.

In a 2015 survey by the Federal Reserve, 46 percent of respondents said they didn’t have enough cash on hand if they had to pay for a $400 medical emergency. Of these, 38 percent said they would use their credit card and pay it off over time. Only 4 percent said they would use a payday loan or bank overdraft to cover the cost. (The results were an improvement from 2013 when half of all respondents said they couldn’t come up with the same amount.)

Payday customers themselves are often outraged at the rates they're charged.

"I don't want to talk about it, but I'll say, it's too expensive,” says one woman, who declined to give her name after exiting the Payday Loan Store in Chicago. She says she was ready to swear off payday loans entirely. But she wanted to go see her son in Arizona.

She had recently paid off a two-week loan of $300, shelling out $46 in interest. "And that's barely two weeks!" she said. 

Consumer advocates, who say almost any alternative would be better than payday loans, are disappointed the proposed federal rules don’t clamp down even more. Lobbyists for payday lenders, by contrast, say the regulations would imperil short-term, small-dollar lending and hurt borrowers that have few other options.

Experts agree the new rules are likely to dramatically consolidate the industry, which has around 16,000 stores in 36 states – more outlets than McDonald’s has nationwide.

Typical APR based on average rate for a $300, two-week loan advertised by the largest national payday chains Center for Responsible Lending

But the new rules also help level the playing field so that alternatives to storefront lenders, including community banks, credit unions, and online lenders can compete on more equal terms.

At the heart of the CFPB’s proposal is a strong emphasis on lenders vetting customers’ ability to repay loans. That process, known as underwriting, is what traditional lenders do all the time. The 1,300-page rule book would also make it harder to roll over short-term loans, which incurs extra costs. And it would prohibit payday lenders from making unannounced debits from borrowers’ bank accounts, which trigger extra fees and deepen their debt load.

The new rules are an important step, says Jeff Zhou, cofounder of Fig Loans, a Texas-based startup that publishes online its loan portfolio. “We think the regulation will drive lenders to offer products that are ultimately more aligned with the welfare of their customers,” he says via e-mail.

One proposal – a cap on how much borrowers could repay per month based on 5 percent of their income – would have encouraged large banks to enter the small-loans market, because they could offer a standardized product at much lower interest rates, says Pew's Mr. Horowitz. But the CFPB dropped the proposal after heavy lobbying by the payday loan industry.

Not far from the Payday Loan Store outlet in downtown Chicago is an AmeriCash store. Business is slow this afternoon. A manager says the company no longer offers payday loans, though a sign outside still advertises them. Instead, customers can apply for installment loans for longer terms, which may reduce the potential for default. But they still charge $14.35 in interest per $100 every 13 days. The manager, who declined to be named, said the busiest periods were winter holidays and at the start of school terms.

Not all payday borrowers are trapped in a debt spiral, says Jonathan Morduch, a professor of public policy and economics at New York University who runs a research project that tracks the finances of 235 households on low and moderate incomes. “Some households use them widely. They have a short-term crunch, and payday loans are very useful. They repay them quickly and move on,” he says.

While payday lenders target low-income communities, their customers are above the federal poverty line: Pew found that a typical borrower earns $30,000 a year. Those that turn to payday lenders have usually exhausted other options, including relatives and friends.

“When families need money they usually turn to other family members. This is an early line of defense,” says Diana Elliott, a researcher at the Urban Institute who studies financial security.

Many low-income families lack a cushion of savings, and their earnings can be volatile if they work in jobs where weekly hours vary. “People run into financial emergencies all the time. Had there been sufficient savings there’s no need to go to a payday lender,” says Ms. Elliott.

Payday lenders aren’t profitable by the standards of the financial industry, in part because of high overheads and the risk of default by borrowers. Horowitz is skeptical that online lenders will meet the need by underwriting small loans if payday lenders consolidate. Many online lenders still charge annualized rates of 200 percent. “It’s not an easy thing to lend online to customers with damaged credit scores,” he says.

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