State lawmakers need to be on the alert: Big changes are underway in the payday loan market, many of which will be detrimental to borrowers and socially responsible lenders. Longer-term, high-cost payday and auto title installment loans have spread dramatically as companies diversify their business models in an attempt to reduce reliance on conventional payday loans. However, without state-level safeguards, these longer-term products often have excessive prices, unaffordable payments, and unreasonably short or long durations, and therefore can be as harmful to borrowers as conventional payday loans.
State lawmakers who want a well-functioning market for small loans will need to establish strong but flexible safeguards to protect consumers and ensure transparency. Legislators in states where payday loan stores operate should consider measures similar to Ohio’s Fairness in Lending Act (H.B. 123), which was passed in July. The law tackles the main problems in the market by lowering prices, requiring that payments be affordable, and giving borrowers reasonable time to repay. It also includes crucial provisions to balance the interests of consumers and lenders, thereby ensuring widespread access to credit.
Table 1
| Problem | Ohio's law |
|---|---|
| Loan durations are too short, which leads to unaffordable payments and frequent reborrowing. | Borrowers will have at least 3 months to repay a loan, or monthly payments on short-term loans will be limited to 6% of the borrower’s gross monthly income. |
| Loan durations are too long, which extends indebtedness and drives up the cost of borrowing. |
Total loan costs will be limited to 60% of loan principal, which eliminates lenders’ incentive to set unreasonably long repayment terms. |
| Prices are far higher than necessary to ensure widely available credit. |
Allows lenders to charge 28% interest plus a reasonable monthly maintenance fee. This is substantially lower than typical payday loan pricing but sustainable for efficient lenders, meaning credit will continue to flow. |
| Front-loaded charges make refinancing costly and prolong indebtedness. |
Requires equal payments consisting of principal, interest, and fees combined, with strong protections against front-loaded fees. |
Source: The Pew Charitable Trusts
Ohio’s law is not perfect. Ideally, it would have required all covered loans to have payments that did not exceed 5 percent of a borrower’s gross income (or 6 percent of net income), capped total costs at 50 percent of loan principal instead of 60 percent, and prohibited front-loaded fees. (Though small, the allowed $10 fee for cashing the loan proceeds check is a hidden fee that has little, if any, justification because the lender is taking no risk in accepting a check that it originated.) But as The Pew Charitable Trusts explained in written comments to legislators, the Fairness in Lending Act is a major advance in protecting Ohio consumers who take out small loans, and it is a model for other states that have payday loan stores. What follows is a summary of the key problems that the law addresses.
Research has shown that conventional payday loans are untenable because they are due in full too quickly—usually about two weeks—and the required payment consumes a third of a typical borrower’s paycheck. Also, payday lenders are the first creditors to be paid because they can access the borrower’s checking account on payday. While this strong ability to collect payments helps credit flow to borrowers with damaged credit histories, it also means that lenders generally do not make sure that borrowers can repay the loan and successfully meet their other financial obligations. To more closely align the interests of borrowers and lenders, state policymakers should ensure that these loans are safe and affordable by limiting monthly payments to 5 percent of a borrower’s gross paycheck. In Ohio, as part of the compromise, lawmakers gave borrowers at least three months to repay and limited monthly payments on short-term loans to 6 percent of gross monthly income.
Small installment loans with unreasonably long durations can result in extremely high costs because only a small proportion of each payment reduces the principal; the rest goes toward interest and fees. For instance, a $300 loan with an 18-month term can result in a total repayment of nearly $1,800—or roughly six times the amount borrowed. To ensure that the repayment period is not excessive, lawmakers should limit total loan charges to half of the amount borrowed. Thus, the maximum charge on a $300 loan would be $150. This would ensure that lenders not reap additional fees by setting unnecessarily long terms. Ohio lawmakers limited total loan costs to 60 percent of the amount borrowed.
Payday lenders charge more than necessary to make credit available, but states can lower costs while still enabling businesses to make a profit. For example, Colorado’s 2010 reform resulted in the lowest-priced payday loan market in the country while maintaining widespread access to credit. In 2016, an average payday installment loan of $392 in the state lasted three months and cost $119 (129 percent annual percentage rate, or APR); nevertheless, payday lenders that operate profitably in Colorado charge borrowers in other states much higher prices. In Ohio, payday lenders will be allowed to charge slightly more than in Colorado for the shortest loans and slightly less for those stretching six months or longer, with APRs declining automatically as loan amounts increase. This structure sets up a well-balanced market and enables loans of up to $1,000 without putting consumers in danger.
Providing a safe installment loan marketplace requires a predictable path out of debt. Lawmakers can achieve this by mandating that small-dollar loans be repaid in substantially equal installments of interest, fees, and charges combined and that upon prepayment or refinancing, all loan charges be pro rata refundable, meaning borrowers would not pay for any days remaining on the loan after it was fully paid back. By contrast, allowing prepayment penalties or front-loaded charges, such as nonrefundable origination fees, creates a strong incentive for lenders to push borrowers to refinance in the early months of a loan and acts as a penalty for borrowers who pay off the loan early.
State lawmakers can take steps to make small loans safer for consumers while still enabling lenders to provide credit and make a profit. Ohio legislators did just that. If other states want to follow suit, they should enact measures that address current market problems—using solutions outlined above—and include in their legislation other consumer protections that Ohio addressed in its Fairness in Lending Act.
Nick Bourke is the director and Olga Karpekina and Gabriel Kravitz are senior associates with The Pew Charitable Trusts’ consumer finance project.