Small-dollar loans, big problems: how states protect consumers from abuses and how the federal government can help.

• Author: Plunkett, Leah A.
• Position: Consumer Law Symposium

I. INTRODUCTION

Across America, drivers pass twice as many payday loan storefronts as Starbucks coffee shops. (2) In twenty-nine states, there are more payday lender stores than McDonald's restaurants. (3) Numerous research studies warn of the dangers associated with payday loans, including significantly higher rates of bankruptcies, evictions, utility shut-offs, and involuntary bank account closures. (4) Many states have recognized the dangers posed by payday and other types of small-dollar loans with predatory features, prompting them to adopt laws to combat the abusive nature of these loans. These laws, however, offer consumers varying degrees of protection.

Historically, states have used their police powers to protect consumers from predatory lending. This Article discusses the extent to which each state's current laws protect consumers from lending abuses associated with four common small-dollar loans: payday loans, auto-title loans, six-month installment loans, and one-year installment loans. (5) Specifically, this Article highlights the findings from the 2010 Small Dollar Loan Products Scorecard (Scorecard), which updated the original 2008 Scorecard (6) Both the 2008 and 2010 Scorecard grade state laws based on the maximum annual percentage rate (APR) they allow for the four typical small-dollar loan products listed above. Since the 2008 Scorecard, there has been significant state legislative activity across the country related to small-dollar loans. Only a handful of states, however, have enacted new measures that adequately protect consumers. This Article provides policy recommendations to guide ongoing reform efforts.

The Article highlights three key points. First, states should continue their longstanding good fight on behalf of American families against abusive, small-dollar lending, but they need help. Congress and the Consumer Financial Protection Bureau (CFPB), which President Obama established when he signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law on July 21, 2010, should join the battle. (7) Second, the states and Congress should focus their reform efforts on enacting an across-the-board usury cap of 36% APR on all small-dollar loans. Third, the states, CFPB, and Congress should impose several restrictions on high-cost (over 36% APR), small-dollar lending to help curb its abusive nature.

In this Article, Part ii describes the methodology used by the 2010 Scorecard. Part iii reports the major changes that have occurred in the two years since the Scorecard's original 2008 publication. Finally, Part IV proposes several policy recommendations, at the state and federal level, with the focus in the latter category on opportunities for action by the newly created CFPB.

II. METHODOLOGY USED FOR THE 2010 SCORECARD

1. The Small Loan Products Evaluated by the Scorecard

   The 2010 Scorecard evaluates all fifty states and the District of Columbia on four categories of small-dollar loan products and examines whether the states have criminal usury caps for these products. (8) This section describes the four loan products included in the 2010 Scorecard: payday loans, auto-title loans, six-month installment loans, and one-year installment loans.

   1. Two-Week, $250 Loan ("Payday" Loan)

      A payday loan is a short-term cash loan based on the borrower's personal check held for future deposit or electronic access to the borrower's bank account. (9) A borrower writes a personal check for the amount borrowed plus the finance charge and receives cash. in some cases, instead of writing a check, the borrower signs over electronic access to his or her bank account to receive and repay the loan. Payday loans are made at stores and via the internet.

      The lender holds the check until the next payday when the total of the cash received and the finance charge must be paid in one lump sum. To pay a loan, the borrower can redeem the check for cash, allow the check to be deposited at the bank, or just pay a new finance charge to roll the loan over for another pay period. When state law prohibits rollovers, a sham in which the borrower redeems the check, immediately reborrows the same funds, and pays another loan fee may be used to accomplish what is, in effect, a rollover.

      unfortunately, even a borrower who is able to repay the loan when it is due may be left with inadequate funds to cover other expenses and may wind up taking out another payday loan immediately or shortly after repaying the prior one. This back-to-back borrowing is known as "churning." (10) A study by the Center for Responsible Lending concluded that 76% of payday loans are the result of churning (defined as a borrower taking out a new loan within the same two-week period as closing out an old loan). (11)

      To get a payday loan, a borrower needs to have an open bank account in relatively good standing, a steady source of income, and identification. Payday lenders do not conduct a full credit check, establish a debt-to-income ratio, or determine whether a borrower can afford to repay the loan when it comes due.

      The typical duration for payday loans is two weeks. in 2009, the median payday loan amount in the country was $350. (12) This represents an increase from as recently as 2005, when the typical payday loan amount was in the range of $250 to $300. (13) The maximum loan amount permitted depends on state law. Some states have a tiered pricing system and, for ease of calculation, the original Scorecard chose an amount ($250) that would not trigger more than one tier. (14) For example, Colorado permits a fee of 20% on the first $300 and 7.5% on the balance. (15)

      The statutory backup to the Scorecard also tracks whether states permit lenders to hold borrowers' checks or to obtain authorization to debit borrowers' bank accounts. The practices of check holding and electronic debiting give lenders access to borrowers' bank accounts with no further action by borrowers after the loan is made. internet lenders rely heavily on the ability to debit electronically from borrowers' bank accounts. Lenders may also include fine print in their loan contracts to permit them to create and submit an unsigned check for payment using a borrower's account information to collect funds from the borrower's account even if the borrower revokes debit authorization.

   2. One-Month, $300 Auto-Title Loan

      To obtain an auto-title loan, a borrower signs over the title to a paid-for car and, in some states, provides the lender with a spare set of keys. (16) The loan is usually due within a month in one balloon payment. if the borrower fails to repay the loan, the lender can take possession of the car and sell it. in some states, title lenders are allowed to keep the surplus from the sale of the car, allowing them to reap a windfall from the borrower's default. The lenders typically perform no assessment of ability to repay.

      Typically, a car title loan is due in one month and has a principal amount of approximately $300. The Scorecard based its APR calculations on a $300 loan.

      Auto-title lenders typically do not make large loans. The loan size is dependent on the value of the car and usually represents no more than 30% to 50% of the vehicle's value. This practice ensures negligible losses if the car is taken by the lender and sold in the event of default. In some states, such as South Carolina and California, lenders make larger loans secured by car titles to avoid limits on interest and fees for small loans. (17)

   3. Six-Month, $500 Unsecured Installment Loan

      Short-term installment loans are offered by different types of lenders, but are most commonly made by finance companies. These lenders normally assess the ability of the borrower to repay the loan. Repayment is usually made in installments of equal amounts that cover both principal and interest. Interest rates and APRs can be lower for borrowers with better credit records or scores. if the borrower defaults, the lender can obtain a court judgment for repayment of the loan. The Scorecard uses a loan that is slightly larger than either a payday or auto-title loan to compare the cost of an installment loan as opposed to a single-payment loan.

   4. One-Year, $1000 Unsecured Installment Loan

      The Scorecard uses an unsecured installment loan with a longer duration to provide another point of comparison to payday and auto-title loan products. The structure of this loan is similar to the six-month, $500 unsecured installment loan.

   5. Criminal Usury Cap

      The Scorecard assesses whether a state maintains a criminal usury cap. Criminal usury caps can provide an outer limit to allowable interest rates. Three states have criminal usury laws that set maximum rates and apply regardless of other state laws. Twenty-eight jurisdictions have not enacted a criminal usury law. Twelve states set a cap in their criminal law that does not apply if another state law allows a higher rate. Five states have a general criminal usury law that makes it a crime to violate the usury caps in other state laws, but does not itself set a rate limit. Finally, three states make exceeding the criminal usury cap a crime only if the lender also threatens or uses violence; however, in one of these states, there is no criminal liability based on the rate cap violation if the rate charged is otherwise authorized by law.

2. Grading Scale

   The four small loan products are graded on a pass (P) or fail (F) basis based on the APR for the loan product. (18) if the loan product's APR is less than or equal to 36%, the grade is a P. (19) if the state "prohibited" a payday or auto-title product, the grade is a P. (20) If the loan product's APR is greater than 36%, the grade is an F. if there is "no cap" on the loan product's APR, the grade is an F.

   Criminal usury statutes are somewhat more complicated because of their interplay with other state laws. A handful of these laws set an absolute cap that applies to all loan products evaluated in this Scorecard. For these...