Earlier this month, the federal Consumer Financial Protection Bureau (CFPB) proposed new rules to regulate payday lending – the business of offering high-cost short-term loans to Americans on terms that many consumer advocates consider predatory.
Once finalized, the CFPB’s rules will likely greatly thin the ranks of payday lenders, whose storefronts once outstripped that of McDonald’s and Starbucks nationwide. The industry’s trade association, the Community Financial Services Association of America, estimates that more than 20,600 payday lending outlets now operate nationally, offering more than $38 billion in loans every year.
It will still be many months, however, before the CFPB’s proposed rules begin to bite. The public comment period doesn’t close until September, and the regulations won’t take effect until 15 months after the final rule. The industry is also promising a prolonged fight.
Given these prospects, some advocates and innovators are pursuing an alternative strategy to beat back payday lenders: By outcompeting them with what they say are “safer” and more appealing products.
In contrast to high-cost payday loans – where the finance charges typically translate into annual interest rates of 400 percent or more – these new loan options are less costly for borrowers (while still profitable for lenders) and won’t trap households in a spiral of debt. Many of these options also promise to help borrowers build credit and even save.
In the town of Cuyahoga Falls, Ohio, for example, city employees are now receiving an unusual benefit: the ability to borrow up to $3,000 in advances against their future pay. Workers who take out a loan have up to a year to pay it back, and the payments are automatically deducted from their paychecks. The annual interest rate is 24 percent.
This new employer-sponsored loan benefit, called “TrueConnect,” is the creation of Employee Loan Solutions, Inc. (ELS), a three-year-old California-based start-up founded by three former employees of the in-house product innovation unit at Intuit, the makers of TurboTax. ELS Co-founder Doug Farry says his company is now working with several dozen employers in four states and reaching roughly 10,000 workers nationwide.
Farry, who also helped launch the Coalition for Safe Loan Alternatives, says his product includes several features to ensure that borrowers don’t get caught in the cycle of debt for which payday loans are notorious for perpetuating. According to the Pew Charitable Trusts, many payday borrowers end up renewing their original loans repeatedly or taking out new loans to pay back old ones. The average payday borrower, Pew finds, takes out eight loans a year and spends more on paying interest than on paying back principal.
In Cuyahoga Falls, Ohio, city workers can borrow up to $3,000 against their future paychecks. Officials are hoping this benefit will reduce reliance on payday lending.
Farry’s customers, on the other hand, can’t borrow more than what they can pay back with 8% of their paycheck. “It’s pretty conservative,” says Farry. “We want 92 percent of their pay to be available for a rent payment, a car payment, medical insurance and other day to day expenses.” Moreover, Farry says, on-time payments are reported to credit bureaus so borrowers can build up their credit scores.
Victor Pallotta, the Cuyahoga Falls City Council member who led the effort to bring this program to city employees, says the loans are meant to tide over workers with short-term cash flow problems or an unexpected financial emergency. But he also hopes to divert as many customers as he can from the hundreds of high-cost payday and car title lenders doing business in his state.
A 2015 analysis by the Center for Responsible Lending finds that 836 lenders offer short-term payday or auto title loans in Ohio, at annual interest rates of between 228% and 763%. Despite voter-approved legislation capping interest rates at 28%, these lenders have continued to offer high-cost loans via a loophole in state law, which the Ohio Supreme Court ruled permissible in 2014.
Pallotta says he has fought the payday lending industry for years, including through such tactics as zoning regulations to limit where storefronts can locate and through a variety of legislative efforts. But with the state legislature’s continued refusal to enforce the limits on the books, Pallotta finally changed his strategy.
“I was at a dead end trying to change legislation and the only way to help people was to try to initiate an alternative lending situation,” he says. In 2015, he proposed paycheck advances as an employer-sponsored benefit, which the City Council approved unanimously. In the first five months after the loans became available, 14 of the city’s roughly 500 employees took advantage of the benefit. “We saved 14 families from losing their cars or getting caught in a payday lending cycle,” Pallotta says.
Policymakers like Pallotta argue that even if tougher regulations can put a dent into the payday lending industry, it won’t diminish Americans’ need for small-dollar, short-term loans. A new Federal Reserve survey finds that in 2015, 46% of Americans lacked the cash on hand to cover an unexpected $400 expense. Twenty-two percent in the Fed survey also experienced a major unexpected expense in the prior year, such as for an accident or illness, which also oftentimes resulted in debt.
12 million Americans now rely on payday loans every year – evidence of a vast underserved market.
According to Pew, as many as 12 million Americans every year cover their cash shortfalls with a payday loan. The volume of these loans, advocates say, is evidence of a vast, grossly underserved market that has so far been monopolized by the payday lending industry.
“A huge percentage of the American population is not being adequately served by financial institutions with existing products,” says Ryan Falvey of the nonprofit Center for Financial Services Innovation (CFSI).
To encourage the development of better financial services products, Falvey’s organization, together with JPMorgan Chase, launched an incubator for promising “fintech” start-ups, called the “Financial Solutions Lab.” This five-year project, which Falvey oversees as the managing director, holds annual competitions to find and accelerate innovative products that can help Americans better manage their money and deal with financial shocks. Last year, Falvey says, 298 companies applied to work with the Lab.
Among the growing group of startups in the space are companies such as FlexWage, whose “WageBank” benefit allows employees to take pay advances on hours that have been accrued but not yet paid. Another company, Even, developed an app that helps people cope with unpredictable paychecks that contribute to financial instability. The app calculates a worker’s average pay and then ensures that this amount will be available every month. Above-average wages are set aside for use in leaner months or used to pay back prior advances. For example, a server working irregular shifts could use the app to save money during busy months so there’s an automatically available cushion when times are lean.
Despite the wave of innovation, the only way to truly swamp payday lenders might be if banks and credit unions start offering small-dollar, short-term credit products too.
“The four largest banks in the country have more branches than all of the payday loan stores combined,” says Nick Bourke, Director of the Small Dollar Loans Project at the Pew Charitable Trusts. While Bourke supports innovations such as employer-based loans and financial management apps, “the only way to really combat this problem is if we have large scale alternative programs from banks and credit unions that can reach millions of people,” he says.
But his can only happen, Bourke says, if the CFPB offers up clear “product safety guidelines” in its final rules on payday lending. That way, mainstream banks have the regulatory certainty they need to invest in building new products.
Patrick Adams, the CEO of the St. Louis Community Credit Union agrees. “Nobody wants to deal with the regulatory hangover that comes from doing something wrong or being misinterpreted.” While Adams has been offering a short-term line-of-credit product to his 52,000 members since 2007, he says that regulatory burdens – both perceived and real – have discouraged many of his peers from offering similar alternative products.
“I think depository institutions can enter into this marketplace and should enter into this marketplace, but the CFPB has to institute regulations that set very clear boundaries and within those boundaries allows for us to be flexible, innovative and creative to be able to serve a market that will not go away,” he says.
In the interim, Cuyahoga Falls City Councilman Victor Pallotta is working to get neighboring communities to adopt the same employer-sponsored loan benefit his city employees now receive. So far, both the city of Akron and Summit County officials are considering the idea. Pallotta is also lobbying hospitals, school districts and other large area employers to offer the benefit as well.
“It’s not the only answer, but it’s an answer,” says Pallotta. “When people are desperate and trying to swim, you’re handing them a life preserver rather than an anchor.”
