Regulating Payday Lending

payday-loans2The federal government in the US is developing pioneering rules focused on the short-term, small-sum credit called as payday lending.

Though it appears to be an excellent idea, the plan proposed by the Consumer Financial Protection Bureau is not the method to do it.

Payday lenders provide service to individuals with poor credit who require cash quickly. Lenders normally deliver two-week loans. They are usually a few hundred dollars for a 15% fee and almost 400% annualized.

The terms may appear to be very outrageous, but they would definitely make sense for individuals who need money for minor tasks and do not have any other option to secure money.

However, there are certain conditions associated with these loans. The loans have to be repaid quickly. Since they are not repaid quickly most often, lenders exploit the situation.

Repaying the loan slowly is not encouraged. Normally, borrowers are asked to either repay completely on the due date or extend the total amount of added cost.

Several borrowers extend the repayment and they pay much more in interest and fees than they had borrowed initially. This could result in severe financial distress for the borrowers. This type of dealings accounts for a huge portion of payday lender’s revenues.

The challenge before regulators is to restrict this greedy lending without completely ending a useful service.

Certain states such as Colorado have implemented a rule providing borrowers a minimum of six months to repay the loan’s principal and covering total charges. Since then, interest rates have reduced, payments have become very inexpensive, and the service has remained broadly available.

The CFPB does not have the power to cap finance charges just like Colorado did, but it could implement something similar such as establishing a ceiling of gross income, for e.g., 5 percent, below which it would believe loan payments to be reasonable.

This would be a simple method since payday lenders naturally need a pay stub or other proof of income. This could attract normal banks into the small sum lending business, assisting to reduce annualized interest rates even further.

However, the CFPB has planned a very complicated method (lenders would have to conduct multiple checks in the borrower’s capability to repay), which would definitely slow down the process and increase the cost. Traditional banks would not want to enter the sector. Lenders would be in a position to accumulate more fees throughout the life of a short-term loan.

Hence, it would be prudent on the part of the CFPB to implement the model that has been tested in Colorado. Borrowers must find out the terms before agreeing to any payday loan.

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