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The Mortgage Professor: Is payday-loan crackdown in the public interest? [The Mortgage Professor :: BC-REAL-MORTGAGEPROFESSOR:MCT]

Opinions on the Consumer Financial Protection Bureau's recently announced restrictions on the payday loan industry are likely to fall along political lines.

Those on the right view the move as excessive regulation blatantly inconsistent with the Trump administration's goal of repealing and relaxing federal regulations of all types. Those on the left view it as a long-needed remedy for abusive practices directed toward consumers facing financial troubles who have no better options.

Many in both camps take a stand without fully understanding the major issue involved.

Payday loans are small loans generally in the range of $150 to $400 repayable a few weeks from origination, when the borrower is due to receive a paycheck or some other scheduled payment. The loan is designed to tide the borrower over until the payment is received. The cost of a loan is usually $15 to $20 for each $100 borrowed, regardless of whether repayment is due in one week, two weeks or four weeks.

Payday loans are convenient, quick and readily available without a credit assessment. To assure repayment, borrowers provide lenders with direct access to their deposit account; in effect, borrowers authorize lenders to repay themselves from the borrower's account. In some cases, borrowers secure their loans by pledging the title to their vehicles.

The borrowers who patronize the payday loan market are generally non-savers who spend what they earn. When an adverse event occurs that leaves them short, a payday loan is their best, perhaps only, option. But these borrowers fall into two distinct subgroups. One group, call them the "cautious," need access to payday funds only occasionally, are allergic to the prospect of continuous indebtedness, and do what is necessary to repay their loans when due. The payday market provides a useful function for this group.

The second group, call them the "heedless," run short frequently and borrow from payday lenders without any game plan for repayment. This results in frequent loans or even continuous indebtedness. These borrowers often become addicted to payday loans in much the same way as people become addicted to drugs. For this group, the payday loan market is their drug dealer.

The new rules issued by the Consumer Financial Protection Bureau are designed to maintain payday loan availability for the cautious borrowers while shutting down availability to the heedless.

Lenders are required to determine whether the borrower can pay the loan payments and still meet basic living expenses and major financial obligations both during the loan and for 30 days after the highest payment on the loan. To support the full-payment test, the lender must verify income and major financial obligations and estimate basic living expenses for a one-month period - the month in which the highest sum of payments is due. The rule also caps the number of short-term loans that can be made in quick succession at three.

The industry claims that the rule would force them out of business. And while they might say this even if it were not true, all indications are that it is true. The documentation requirements would result in a significant increase in loan origination costs, which could make small loans uneconomic. In addition, lenders would lose the most profitable part of their customer base.

An earlier study by the CFPB found that among a sample of payday borrowers, only 13 percent had one or two transactions during the 12-month period covered by the study, suggesting that the cautious borrower segment is small. Thirty-nine percent of the borrowers had three to 10 transactions, and 48 percent had 11 or more transactions. That 48 percent produced 75 percent of the loan fees, and an even larger part of lender profits because repeat borrowers require no marketing expenses. This suggests strongly that heedless borrowers comprise a large part of the market.

The core issue then is whether a market should be maintained that is useful to a minority of those who use it but is addictively harmful to a much larger group whose patronage is needed to keep the market alive. The issue is much like that involving gambling casinos, which also have addicted clients. The difference is that gambling addicts are a very small percent of casino patrons whereas payday loan addicts are a substantial percent of payday borrowers.

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ABOUT THE WRITER

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.

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(c)2017 Jack Guttentag

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