Mayday for This Payday Loan Alternative

In rural Bath County, Ky., the median household income is about $30,000 and more than a quarter of its residents live below the poverty line.

To help its cash-strapped community, Owingsville Banking Co. offers installment loans in amounts ranging from $150 to $5,000. The $60 million-asset bank makes dozens of these loans each month to customers who might need $800 to fix a transmission or $1,000 to buy heating oil for the winter, making sure to keep monthly payments manageable to minimize the risk of default.

But the bank might have to discontinue the program — or at least scale it down significantly — if rule changes under consideration by Consumer Financial Protection Bureau are enacted.

The CFPB wants to end what it calls "payday debt traps" by capping the rates lenders can charge, prohibiting borrowers from taking out more than one loan at a time and imposing tough requirements on lenders to assess whether the debt can be repaid within the given time frame.

While payday lenders appear to have the most to lose — many say the rules the CFPB is proposing would put them out of business — community bankers argue that their small-dollar loan programs also would become guaranteed money-losers unless the language of the proposal is substantially revised.

"We don't make money on these loans — at best we break even," says Thomas Richards, an assistant vice president at Owingsville. The proposed changes would make these loans "even less financially feasible," ultimately restricting credit to low-income people who need it.

Richards also says that his bank has been making the small loans for many years and that its regulator, the Federal Deposit Insurance Corp., has never taken issue with this line of business. That could be because the default rate is well below 1%, even though the average borrower's credit score is in the low 500s.

"It's not a problem that needs fixing," Richards says.

Bankers have time to voice their concerns. After conducting a hearing on the topic in late April, the CFPB expects to draft a more formal proposal later this year. Then it must give the public 90 days to comment before issuing the final rules.

The CFPB's proposed rules cover both short-term and long-term consumer loans. The rules for short-term loans largely affect payday lenders and credit unions that offer payday-like alternatives, while the rules for longer-term loans primarily affect lenders offering installment loans. Short-term loans are typically repaid in a single lump sum, usually from the borrower's paycheck, while longer-term loans are repaid in monthly installments.

Bankers are most concerned about a provision in the long-term proposal that would cap the annual percentage rate on loans of 45 days or longer at 36% and require lenders to roll any fees into the APR. Banks generally charge around 18% for these small loans, but if application fees are factored in, then the all-in APR on a $1,000, six-month loan can top 100%, says Rick Burgess, a senior vice president at the $110 million-asset Community Guaranty Savings Bank in Plymouth, N.H.

The CFPB has proposed capping application fees at $20 — an amount, it notes, that credit unions typically charge for consumer loans. But bankers point out that credit unions can afford to keep application fees low because they operate as nonprofits and don't pay federal income taxes. Banks' application fees generally range between $50 and $75.

"A small loan over a short term generates very little interest for the bank, so to compensate the bank for my time, my processor's time, the materials, we need to charge these fees," Burgess says. "If we can't even break even on the loans, it doesn't make any sense to do them."

CFPB spokesman Samuel Gilford says lenders would be allowed to make loans above the 36% all-in APR if they can verify the borrower's ability to repay. However, the verification requirements would go far beyond reviewing a borrower's pay stub; lenders would have to factor in all major debts, and possibly estimate all living expenses, including utilities, food and gas.

"Banks don't do that level of underwriting for consumer loans," says Virginia O'Neill, a senior vice president at the American Bankers Association.

Banks also could continue to make loans above the 36% all-in APR if they capped monthly payments at 5% of the borrower's income. A report from the Pew Charitable Trusts two years ago found that most borrowers cannot afford to put more than 5% of their gross income toward a monthly loan payment and concluded that higher payments should be banned unless lenders could demonstrate that borrowers could afford more.

Banks, though, don't want to stretch loans much beyond a year or 18 months, so to keep payments below the 5% cap they would likely have to reduce loan amounts, Burgess says. He argues that the low default rate of these loans proves borrowers can afford to apply more than 5% of their income to monthly payments.

Because small-dollar lending is not a huge business for banks, the worry is that the CFPB is not taking bankers' concerns seriously. Of the 27 businesses invited to discuss the proposed new rules at the Small Business Regulatory and Enforcement Act hearing on April 29 — which was closed to the public — only three were community banks.

Still, in low-income communities throughout the country, factory workers and farm laborers rely heavily on emergency credit from local banks. The Bank of Fayette County in Moscow, Tenn., makes roughly 100 small loans a month to customers with poor credit because the demand is there and "it's our job to help people," says McCall Wilson, the CEO of the $340 million-asset bank. "There's no safety net for these people," he says. "If their hot-water heater goes out or their transmission blows, what do they do? They don't have a credit card."

Wilson says that if the CFPB really wants to stamp out payday lending, then it needs to make it easier, not harder, for banks to offer small consumer loans. He has long argued that more banks would offer such loans if regulators reduced the loan application to a single page. Less paperwork means lower fees for consumers, which is ultimately what regulators want, Wilson says.

"Payday lenders sprung up because banks were not in this business and couldn't make money doing this," Wilson says. "If you make it easier for banks to do it, payday lenders won't exist."

Nick Bourke, the director of Pew's small-dollar loans project, agrees — and he is optimistic that the CFPB will address banks' concerns. He says most borrowers are repeat customers who bankers know intimately, so it makes sense for the CFPB to relax the ability-to-repay requirements for banks. "People are better off with properly structured installment loans with small, manageable payments than they are with conventional balloon-payment payday loans," Bourke says. "I get the strong sense that the CFPB is making a big effort for responsible lenders to stay in the business."