On June 2, 2016, the Consumer Financial Protection Bureau (CFPB) proposed new rules to regulate payday loans, automobile title loans, and some open-ended and high-cost installment loans. Nevermind the question on whether this constitutes an overreach of authority. Let’s assume the proposed rules are approved. How should lenders in these sectors implement policies that ensure they comply with the rules, seeing as there will undoubtedly be hefty penalties for non-compliance?
The proposed rules
- The first rule is a “full-payment test”. Lenders will be required to make an up-front determination as to whether or not borrowers can repay a loan without needing to reborrow.
- Some short-term loans and risky long-term loans will require a “principal payoff option” for borrowers who cannot meet the full-payment test.
- Before approving loans, lenders will be required to ensure borrowers can afford to make each payment installment or lump sum payment when it’s due.
- Lenders will be required to verify all after-tax income of borrowers from all sources.
- Lenders will also be required to check consumer credit reports for outstanding loans and required payments.
- On payday and single-payment auto title loans, lenders will be required to verify borrower income to ensure the borrower can meet all financial obligations including basic living expenses throughout the loan term and for 30 days after loan pay-off or when making the loan’s highest payment.
- For high-cost installment loans, lenders will be required to ensure borrowers can make all payments when due including balloon payment and all financial obligations as well as basic living expenses throughout the loan term and for 30 days after loan pay-off or when making the highest payment.
- The requirement for installment loans without a balloon payment will be for lenders to ensure borrowers can make all payments and meet all financial obligations including basic living expenses throughout the loan term.
- For reborrowing, lenders will be required to ensure a borrower’s financial situation has improved since the last loan, and reborrowing will be limited to no more than three successive loans followed by a mandatory 30-day cooling off period.
- For refinancing high-cost installment loans, lenders will be required to ensure a borrower’s financial situation materially improves since the original loan was made unless the installment payments will be lower or the total cost of the loan will be less than the original.
These are hefty requirements and will apply to banks, credit unions, and non-bank lenders whether they operate online or in storefronts, and regardless of licensing authority.
It is unclear if these new rules will help the borrowers get better credit products or understand the lending products they receive. However, the big winners, if these rules pass, will be the credit bureaus and the alternative data providers. Most borrowers targeted by the CFPB rules are not customers of the standard credit bureaus like Experian , Equifax or TransUnion because they have very low credit or no credit. Therefore companies like PRBC.com , which we covered here, who can provide useful data to help meet the CFPB requirements, stand to be the big winners with these rules for sure.
Effect on lenders
So how should lending institutions impacted by these new rules move forward to ensure they don’t run afoul of the law and remain profitable to continue doing business?
It should be self-evident by these proposed rules that no-application loans will be a thing of the past. In order to comply with the CFPB rules, you’ll have to gather certain information from borrowers or risk penalty. At a minimum, you’ll need to know
- The borrower’s weekly or monthly income
- Current debt load or credit
- How much the borrower pays in rent or mortgage each month
- Credit history and credit score
- Borrower’s total monthly commitments to creditors, utilities, landlords, and all other sources
- Bank account information (checking and savings)
All lending is based on risk. Higher-risk borrowers should pay higher interest rates and have more unfavorable payment terms. The proposed CFPB rules places no restrictions on those. But as a lender, you’ll have to do your due diligence on every borrower to determine whether or not that borrower is a good credit risk and, if so, how much of a risk they are. You can, and probably should, base your loan repayment terms on that risk assessment. One way to do that is to assign every borrower a risk rating, which you can do through the loan approval process.
Assuring the Ability to Repay
The bottom line on payday and auto title loans is that the borrower be able to repay the loan. Of course, you cannot manage the borrower’s money for them, and there is no guarantee that any level of due diligence on your part will ensure that the borrower actually repays the loan. Your need for due diligence is simply to ensure the borrower has the ability to repay. These recommendations are based on that due diligence goal.
I favor a point system. Your first step should be to establish some rules for how you will assign points and to determine what point value is necessary to approve a payday or auto title loan.
- Start with establishing a minimum income threshold based on the amount of the loan. Understand that low-income borrowers have basic living expenses, which include rent and utilities, food, and incidentals. Some housing authorities recommend the poor spend no more than 30% of their income on rent. This is a simple calculation, but it may not be realistic. An individual earning just $2,000 per month income, for instance, could only pay $667 per month in rent, but there are places where finding a place to live for $667 a month is not even possible. While the 30% rule may be arbitrary, it is simple; just to ensure you meet the CFPB requirements, you could establish a 30% rule for such loans and cap borrowers at 30% of their monthly income. An alternative would be to establish such a rule for monthly payments, say, not to exceed 5% of income. In terms of lump sum installments, you could impose an arbitrary standard of 10% of income. You’ll have to ensure that whatever standard you use for loan-to-income ratio—and I recommend you come up with your own numbers—that it is realistic and flexible enough to apply across the board to any income level of borrower.
- Establishing an arbitrary loan-to-income ratio, however, will not be enough. You’ll have to ensure that borrowers have the ability to pay that amount. Will they be able to make the monthly payments based on their current commitments? Will they be able to pay off the entire loan amount? To answer that question, you’ll have to gather information about their current debt load. By using a point system, you can assign a point value based on meeting the loan-to-income ratio and another point value based on current debt load. There are two practical ways to achieve this:
- Assign points based on each debt in place. In this scenario, you might assign a negative 1 point for each loan or line of credit the borrower has. So, if they have a car loan, furniture rental debt, purchased a television set on credit, and three credit cards, that would be -6 points. If you assign five points for meeting the loan-to-income ratio, then this borrower is at -1 point.
- Another way to assign points based on debt burden is to assign points based on a cumulative dollar amount of all debts. The higher the debt load, the lower the points.
- Since you’ll be required to check credit for borrowers, you should include credit scores in your point system evaluation. Simply assigning points based on Good, Fair, or Bad credit is enough.
- Another thing you might look at is the history of like credit. If a borrower has a habit of taking out payday loans and they are applying for a payday loan with your company, what is their history in paying back such loans? Do they frequently have late payments? Are they in default on any such loans? Include a point system for any negative reports for similar types of credit.
- Does the borrower have a savings account? How much is in their checking account at the time of the loan? Assign points based on liquid assets at the time of the loan. Many poor people will not have a savings account and may not even have a checking account. If they do, however, count that as a positive toward ability to repay. You can also assign points based on current liquid assets; the more liquid assets a borrower has, the better the ability to repay the loan and therefore the more points you can assign them in the risk assessment process.
You may want to establish other criteria. Maybe you want to assign points based on total income or occupation. Should police officers and school teachers be given a higher degree of risk privilege than strippers and bartenders? Remember, you don’t have to disclose to the borrower what your risk assessment protocol is; you’ll just need to have one.
The key to ensure that borrowers have the ability to repay is not to remove all doubt. Rather, the idea is to evaluate the borrower’s current income and debt commitments to determine whether or not it is feasible to repay the loan and to ensure that you can prove to the CFPB that you have done some due diligence on each borrower. If you can do that, you should be able to continue making loans to those who need them and keep your head above the regulation waters.