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Are payday loans abusive? Should they be more powerfully regulated? originally appeared on Quora – the place to build up and share skill, empowering people to learn from others and better understand the world.

Contrary to what many people might otherwise believe, the payday loan industry is in fact very regulated. The problem lies in the fact that existing regulations (mostly) haven’t kept rhythm with shady business practices, don’t necessarily end up with the results that people want, and often are just not crafted well.

To drill down deeper into the specifics of regulation, I’m going to very first go over existing Federal regulation. Next, I’m going to cover state-level regulation in brief, and then concentrate on the jurisdictions where I’m most familiar: the state of Texas and, at the municipal level, the city of Houston. These are the areas where my company operates and where I have the most practice.

To conclude, and to actually reaction the question, I’ll talk about some of the truly questionable practices from payday lenders and how regulation can (and most likely ought) to be used to address them… but also talk about the boundaries of legislation. Note that none of this should be construed as legal advice.

Federal Regulation in the United States

The payday lending industry, controversial as it is, is not a stranger to regulation. All lending in the United States, for example, is regulated by the Equal Credit Chance Act (ECOA), a Civil Rights-era law that makes it unlawful for any creditor to take into account race, color, gender, religion, national origin, marital status, age, and whether income comes from public assistance programs when underwriting loans. This is a law that was intended to end the de facto discrimination against minorities – primarily black people – who desired to take out mortgages. In general the protections to all classes covered by ECOA are taken very gravely today.

All lenders must also obey consumer protection regulations like the Truth in Lending Act of 1968, which regulates and standardizes disclosures for lenders and is the regulation underlying the legally required fee and cost sheets provided for every loan product. Misleading disclosures or false advertising can lead to hefty fines.

In addition, the US has one major Federal usury law, the Military Lending Act (MLA), which specifically prohibits suggesting loans above 36% interest to active duty military personnel or their spouses, as well as banning certain practices like early repayment fees. (For this reason, the vast majority of petite dollar lenders, including my company, cannot lend to active duty military personnel or their spouses.)

As an aside, the fact of the matter is that payday lenders and all petite dollar lenders in general tend to obey the law of the state(s) they lend in. This is in distinct contrast to many other types of lending products like credit cards, automotive lending and mortgage lending, which rely on an obscure US Supreme Court ruling from 1978, Marquette National Bank of Minneapolis vs. Very first of Omaha Service Corp. This ruling from the Supreme Court held that state anti-usury laws cannot apply to nationally chartered financial institutions, which permitted states like Delaware and South Dakota to export their relatively relaxed usury laws to the rest of the country.

Unlike nationally chartered financial institutions, there is no way for a puny dollar lender to be nationally chartered (which implies being directly chartered by the US Treasury and in some cases participating in the Federal Reserve system). All lenders are state chartered, and thus have to obey the laws of the state they are chartered in. Many of the larger lenders operate as separate companies in a number of different states.

For nationally chartered businesses, there is some degree of legal grey area here that is only recently commencing to be resolved. Theoretically, the same SCOTUS case that authorizes credit card and mortgage lending nationally for Federally chartered banks could also be construed to permit payday lenders, especially online payday lenders, to incorporate in lax regulatory jurisdictions (certain states, areas under Tribal law, etc.) and to lend nationally. In practice, this legal theory isn’t doing too well.

For example, albeit sovereign Tribal jurisdictions are permitted to operate their own payday lending operations online via their own citizens and capital, such as the one run by the Navajo Nation, it is much more common for outward financiers to use a tribal jurisdiction as a front for their own operation, thus permitting it to avoid state consumer protection, usury and racketeering laws. The Department of Justice has recently commenced cracking down on this practice by treating it as a disturbance of the RICO act and other Federal racketeering laws. Additionally, individual states have commenced legally challenging the practice, such as the State of Connecticut’s latest suit against tribal lenders in Oklahoma, while the CFPB has in turn commenced filing Federal suits against tribal lenders by relying on consumer protection law.

The truth is that legally, payday lending on a national level, and especially over the internet, has basically been the Wild West over the past decade or so. Dubious legal theories and regulatory grey areas have permitted a entire ecosystem of online lenders to show up like mushrooms overnight, and then fold when they receive regulatory challenges. Now that legal authorities are cracking down, this era is most likely going to switch drastically.

However, most traditional payday lenders obey national and state regulation. More comprehensive federal regulation was proposed last year by the CFPB, but is unlikely to stir forward in the current regulatory climate.

Outside of these laws, in the US most regulation is concentrated at the state and municipal level. All 50 states of the union in the United States have some form of payday lending regulation, some of them in some unexpected places. There are broadly three regulatory regimes that you can expect to see:

  • Permissive: Least regulated states, which permit for the standard business model of a payday lender– balloon payment (i.e., all interest and principal due on a single day) with initial fees of 15% or greater of the initial balance over 1-2 weeks.
  • Limitary: Most regulated states, typically which either directly or effectively ban payday lending of any type. Rate caps, one form of this regulation in these states is usually 36%. Effective bans in former years also came from states that ban postdated checks, which used to be the only effective way that a storefront lender could operate, tho’ with modern ACH (automated clearing house) charges to checking accounts, this is not indeed an issue any longer.
  • Hybrid: Something in inbetween, with either lower rate caps, limitations on number of loans per borrower, mandating installments or the allowance of early repayment, etc. but still generally permitting high interest-rate lending.

A 2012 probe by the Pew Charitable Trusts gave an excellent overview of state-by-state payday lending regulations. The linked probe contains a list that uses the three categories I outlined and is 16 pages long, hence my desire to leave it to only to the interested.

In the state of Texas, there is significant regulation in place mainly governed by the Texas Office of Consumer Credit Commissioner (OCCC). Texas does, in fact, have a usury law, which is a kind of law that boundaries the amount of interest that may be charged by a creditor. Under Texas law, no creditor may charge an interest rate above 10% without being licensed unless it’s an award from a civil court case judgment (in which case the limit is 18%). Regulated lenders, which can suggest loans above 10%, include mortgage lenders, commercial lenders, auto lenders, pawn lenders, and other lenders specifically provided for in the law. The same section of the legal code also bans prepayment penalties on residential mortgage loans above 12% interest.

In order to operate in the state of Texas, under the Texas State Finance Code Chapter 393, further codified in the Texas Administrative Code Chapter 7, Part Five, Chapter 83, Subchapter B, once above a certain fee and rate cap payday lenders must be registered as “Credit Access Businesses” (CABs) which nominally operate as brokers for a third-party lender and charge a motionless percentage of fees based on the amount of cash advance suggested. This fee, which is on top of the interest charged, is the mechanism that permits any puny dollar lender (including my own company, Fig Loans) to suggest effective interest rates above the local usury law.

To an extent, this regulatory structure makes some degree of sense. Since the majority of the cost of lending a petite dollar loan is actually the immovable cost of underwriting, charging a broker and underwriting fee permits this cost to be defrayed while still obeying usury laws. On the other palm, there is no obligation for the broker to charge at cost. Functionally this permits for virtually unlimited interest rates, subject only to consumer protection laws that require basic due diligence on the consumer’s capability to pay.

Laws of the City of Houston

The municipal regulation present in the City of Houston is much more limitary than that present in the State of Texas. Houston passed a payday loan ordinance in 2013, to the predictable howling of existing businesses. Houston’s legislation is based on the model legislation of the Texas Municipal League. The major features of the ordinance are:

  • CABs must register with the city of Houston
  • No unsecured loan issued by a CAB can be over 20% of a borrower’s gross monthly income; title loans cannot be more than 3% of a borrower’s gross annual income or 70% of the book value of the vehicle
  • Loans cannot have more than Four installments or Three rollovers/renewals, where a rollover is defined as being made within 7 days of the previous one terminating
  • The proceeds from each installment have to pay off the loan principal by at least 25% (functionally, this bans “balloon” installment lending practices that encourage rollovers wherein the final payment is expected to pay off the entirety of the principal while previous payments are affordable amortized interest-only payments)

This 2013 stir was in tandem with a number of other Texas cities including Amarillo, Austin, Baytown, Dallas, El Paso, Galveston, Garland, Midland, San Antonio, South Houston, and others following the state legislature’s failure to agree on any legislation that year. While there is some ambiguity regarding enforcement powers for these ordinances – it is unclear whether cities have any enforcement powers over businesses not registered in the cities in question but doing business within them – municipal legislation is the most proactive level of regulation in Texas. The ambiguity might permit some lenders to claim they can get away with shady business practices, but not necessarily: city of San Antonio prosecuted seven lenders in 2014, for example.

Should Payday Loans be Regulated More?

The unambiguous reaction, in my opinion, is yes. They should. There are a entire host of lending practices that limit the capability of people to get out of debt.

  • In general, payment sizes should be structured so that they are affordable. Installment loan payments should be structured so that they can be reasonably be made by a debtor. Balloon payment loans should either be puny enough that they do not require debtors to hold excessive amounts of cash or be incapable to meet basic expenses without taking another source of credit. This discourages rollovers and the “debt spiral” that occurs from them, and functionally means that above a certain level all loans should be installment loans.
  • Lenders need to take a basic level of responsibility to ensure that they lend to people who have the capability to pay.
  • Penalty fees, including early repayment, late payment, lender’s insufficient funds, and payment rescheduling fees should at minimum be fully and clearly disclosed, and at best ought to be severely restricted. “Hidden fees” are a major aspect of what makes payday lending, and puny dollar lending in general, so expensive and unpayable.
  • The practice of using hot check criminal prosecution to collect bad debts should be banned outright on a proactive basis. The incentives to make them a criminal matter should be eliminated, which includes an aspect of civil asset forfeiture reform as well since many of these incentives revolve around hot check confiscations being used as a slush fund for other expenses. Debt defaults are a civil matter and there should never be any governmental organs involved in debt collection.
  • Deceptive advertising and lead generation practices should be banned effectively. These practices basically advertise low-cost loans but direct you to “partners” who are in fact high-interest payday lenders only. They’re frequently used to get around advertisers’ bans on payday lending advertising.

In general, most consumer advocates share these goals. Notably, interest rate caps are subsumed by these policies, particularly the requirement to make payments affordable.

However, while I think most people can agree that these goals most likely ought to be pursued (and most consumer advocate types would likely wish that I’d go further), there’s good and bad ways to implement regulation. Many types of regulation are crafted without regard to whether or not they will negatively influence the availability of credit to deserving borrowers.

Yes, this is a perennial sob of payday loan lobbyists, but there is a kernel of truth in that many regulators and consumer advocates have very little idea of the limitations that are inherent in the business as it exists now. Moreover, regulations designed to control loan costs can and do have the effect of forcing lenders to tighten their underwriting, restricting credit to higher risk borrowers. Ultimately, certain regulatory requirements, like ones for assessing income and spending, are much lighter said than done.

Successful examples of regulation, like Colorado’s 2010 reforms to payday lending (tho’ the Pew report’s calculation methodology for interest rate reductions shows up to include early repayments) share a few different characteristics:

  • Encouraging installment payments over balloon paymentsReducing or outright banning fees concerning early repayments
  • Limiting the total size of loans based on the borrower’s income
  • Concentrate on enlargening capability to pay to address indefinite debt rollovers rather than directly banning rollovers
  • Concentrate on aligning lenders’ interests with those of borrowers rather than imposing harsher underwriting standards.

However, there are many policies that attempt to make this happen that don’t achieve much of anything. Some of them which I’ve named above as contrasts have effects that range from negligible to actively harmful. For example:

  • Rollover limit and “cooling off period” regulations are ineffectual. The net effect of rollover boundaries from a single lender is to force a borrower to simply switch to a different lender for their financing needs, not to pay off their loan. There are always other options available. Certain states, such as Florida, have a statewide database to prevent this, but there are other potential pitfalls. Regulations of this type also disincentivize interest rate reductions for repeat loans (as my company and some competitors, like LendUp, do) because companies know that they will have trouble retaining customers beyond the third loan. Mandating underwriting methodologies that force lenders to not only assess income but also immovable categories of spending like utilities, rent, and others (as proposed by the CPFB) basically attempts to mandate that the underwriting practices of petite dollar lenders must be closer to those of prime lenders. This leads to one of two consequences: Either lenders transition to suggesting prime credit because of the expense and complexity of underwriting, or it drives major consolidation of the industry because unsophisticated lenders or smaller shops don’t have the capability to efficiently serve with regulation. Besides reducing competition in this market, that kind of regulation would also have the unintended consequence of forcing many nonprofit alternatives out of the market as well.
  • Mandating interest rate caps (like the MLA) effectively bans all puny dollar lending and cuts off access to credit. It fails to recognize the reality that given loss rates and real immobilized costs, petite dollar lending doesn’t make enormous profits and prices very often reflect the costs of the industry.Aggressive licensing policies often backfire or conflict with other layers of regulation. A latest example is the demise of the California branch of the nonprofit Ways to Work’s automotive program. They suggested automotive loans at a loss, but an aggressive California licensing law caused them to exit the state because it would have required every local nonprofit playmate to register as a lender due to their participation. A secondary example can be provided by the conflict inbetween the laws of the City of Houston and the Pew Charitable Trusts’ policy proposal to limit payments to no more than 5% of a borrower’s monthly income. Those clever enough to do the math will realize that this effectively caps the amount that a loan can suggest to someone of a given income to a ridiculous degree due to the Houston ordinance requiring 25% of principal be paid off in each installment, with a maximum of Four installments. For example, a typical low income customer making a take-home pay of 1200permonthcould,atmost,pay240 in total payments, which in the context of typical puny dollar lending terms would translate to a principal of just over $200. That’s too puny of a loan for many firms, too little credit for many customers, and basically results in rationing credit to those with higher incomes. Mandating low payment sizes, beyond a certain point, doesn’t necessarily increase consumer friendliness because the term length, and corresponding total cost of the loan, increases.

I’m part of the team at Fig Loans, a consumer finance startup that supplies low-cost financial services to people without access to the normal credit system. I’m sharing some of the insights from my work at Fig on Quora as part of a puny campaign on our part to raise awareness of financial services for low-income customers with poor access to credit. The only payday advances I give involve candy bars.

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