Constraining consumer access doesn’t solve the payday debt trap

Rep. Terri Sewell’s (D-Ala.) recent post on The Hill points out the most pernicious problems associated with short-term lending.  She suggests that tighter regulations, like those recently proposed by the CFPB, are necessary to protect consumers from the ‘debt trap’ associated with short-term lending.

Restricting access to credit does not solve the payday loan ‘debt trap’, but addressing problematic aspects of the product could. The CFPB can work with lenders to solve the identified problems, such as assessing ability to repay or eliminating products where customers pay more in interest than the original principal borrowed, without effectively putting an entire industry out of business. These provisions, though useful, miss the root cause of the problem and won’t help the 12 million Americans who borrow, many out of necessity, $46 billion annually through short-term lenders.

{mosads}Our elected officials should be encouraging the CFPB to address the problematic features of short-term lending products, particularly those exploited by the bad actors, instead of eliminating an industry entirely.    

If the CFPB enacts rules that essentially put an industry out of business and leaves consumers with no market alternatives, what are consumers to do? The most common answers I hear about what consumers should do instead of using short-term loans are:

They should save more!

I don’t disagree; but when the Federal Reserve finds that 47 percent of Americans couldn’t pay for an unexpected $400 expense with savings or a credit card, but would be forced to sell a possession or borrow, this isn’t an answer.

They should ask family!

While some are fortunate enough to have friends or family members to turn to, many don’t. Of those unable to meet a shortfall of $250, many do not have friends or family with money to lend.

They should go to a bank!

It is not profitable for banks to make short-term loans, or they would be doing so. Despite a low cost of funds, with fixed costs of operations, underwriting, servicing, compliance and charge offs, banks cannot offer loans of a few hundred dollars.

Sewell highlights the CFPB’s proposed ability to repay requirement as a key consumer protection.  While we agree with assessing a customer’s ability to repay, the proposal dictates how the industry must do this. As written, the ability to repay requirements disproportionately impact those who lack traditional income documentation, like paystubs or W-2s, or lack data on major credit bureaus, including the elderly, divorcees, women, minority, and low-income applicants — the very population the proposal is suppose to protect.

A better solution would be to allow short-term lenders to follow the guidance for the banking industry, like reasonable income and expense verification, as provided for in the CARD Act, and the convenience of consumer-initiated electronic payments.

By focusing on the product itself, rather than problematic features and how bad actors exploit them, the CFPB will reduce access for all borrowers – not just less responsible ones. Payments should go towards interest AND principal, which solves for consumers paying interest indefinitely without reducing principal owed. While Sewell is incorrect that lenders presently are ‘first in line’ to a borrower’s bank account, the greater point is that there should be greater control over who accesses the banking system and customer accounts, which NACHA is addressing.

I propose a framework that protects consumers by ending problematic practices, but does not cut off credit to hard working Americans struggling to make ends meet while honoring their financial responsibilities. Reducing access to borrowers who use credit responsibly has proven to increase bankruptcies, lower credit scores, and force borrowers to turn to more expensive options with fewer consumer protections.

As written, the CFPB’s proposal would have the perverse impact of punishing borrowers who pay on time with fewer borrowing choices. It would harm consumers, stifle innovation, and reduce access to the consumers who most desperately need more options. Forward looking, data-driven companies, like LendUp, are solving the problem of access to credit for consumers who are ignored by traditional lenders by creating products that align the customer’s success with business’ and embedding education into the product to encourage responsible behavior.

The LendUp Ladder, LendUp’s alternative to payday loans, replaces a broken product with one that rewards customers who are responsible with lower rates and credit building opportunities over time; protects struggling borrowers with transparent terms and flexible repayment schedules that work for customers.  It’s working: our soon to be released study shows that more than two-thirds of LendUp customers improved their credit score over a three month period. Let’s encourage the CFPB to adopt a framework to incentivize innovation and market alternatives, not a strict set of rules that stifles innovation, inhibits market solutions, and reduces access to credit in struggling low income communities.  

Orloff is the CEO and co-founder of LendUp, a venture-backed startup that builds credit solutions for consumers who banks and traditional lenders can’t help.