In a long anticipated move, the Consumer Financial Protection Bureau (CFPB) proposed a rule to regulate so-called "debt traps" by requiring lenders to take additional steps to ensure consumers have the ability to repay certain types of small loans and placing limits on reborrowing or refinancing.

What happened

The new 12 CFR Part 1041 would generally cover two categories: loans with a term of 45 days or less and loans with a term greater than 45 days for which the lender charges a total, all-in annual percentage rate (APR) that exceeds 36 percent, including add-on charges, and either collects payment by accessing the consumer's deposit account or paycheck, or secures the loan by holding title to the consumer's vehicle as collateral.

All lenders—including banks, credit unions, and nonbanks—would be subject to the proposed requirements for any loan covered by the proposal.

The Bureau would establish a "full-payment test" under which lenders would be required to determine whether the borrower can afford the full amount of each payment when it is due and still meet basic living expenses (such as food and utilities) and major financial obligations. To do this, lenders would need to verify the amount of income that a consumer receives after taxes from employment, government benefits, or other sources. A check of a consumer's credit report (to verify the amount of outstanding loans and required payments) would also be necessary.

Specific to payday and single payment auto title loans, lenders would need to determine that a borrower has sufficient income to repay the loans and to meet major financial obligations and basic living expenses during the term of the loan—and for 30 days after paying off the loan or paying the loan's highest payment.

Installment loans with a balloon payment require lenders to ensure the borrower can make all payments when due, including the balloon payment, plus major financial obligations and basic living expenses during the term of the loan and for a 30-day period after making the highest payment.

The CFPB also proposed additional restrictions on loans, making it more difficult for borrowers to reborrow or refinance the same debt. For example, a borrower may not rollover a loan within 30 days of paying off a previous short-term debt. Lenders could only offer a similar short-term loan if a borrower can demonstrate that his or her financial situation during the term of the new loan would be "materially improved" relative to what it was since the prior loan was made. The same conditions would apply for a third loan and even for borrowers who successfully justified a second and third loan; the Bureau capped borrowers at three loans in succession, putting in place a mandatory 30-day "cooling off" period.

Similar limits were placed on high-cost installment loans. Lenders would not be permitted to refinance the loan into a loan with similar payments unless a borrower demonstrated that his or her financial situation during the term of the new loan would be materially improved relative to the prior 30 days. A refinancing offer could only be made if it would result in "substantially smaller" payments or substantially lower the total cost of the consumer's credit, the CFPB said.

Certain loans could avoid the full-payment test, in what the Bureau dubbed the "principal payoff option." These loans would allow borrowers to take out up to $500 and repay the debt in either a single payment or with up to two extensions where the principal is paid down at each step. Lenders would be prohibited from taking an auto title as collateral or structuring the loan as open-end credit.

This option would necessitate specific disclosures from lenders, who would also be barred from offering these types of loans to consumers with outstanding short-term or balloon-payment loans or who have been in debt on short-term loans more than 90 days in a rolling 12-month period. Only two extensions of the loan could be offered by the lender and only if the borrower pays off at least one-third of the principal with each extension.

Two other longer-term loan options were included in the CFPB's proposal. Lenders could offer loans that generally meet the parameters of the National Credit Union Administration's "payday alternative loans" program, with interest rates capped at 28 percent and an application fee no more than $20. Alternatively, lenders would be allowed to offer loans that are payable in roughly equal payments with terms not to exceed two years and an all-in cost of 36 percent or less, not including a reasonable origination fee, as long as the lender's projected default rate is 5 percent or less. The Bureau said lenders would be limited in the amount of either type of loan they could make per consumer, per year.

Lenders would also be restricted in the number of repeated, unsuccessful withdrawal attempts to collect payment from consumers' accounts, pursuant to the Bureau's proposal, and mandated to provide written notice before attempting to debit the consumer's account for any loan covered by the proposed rule.

Notice would generally be delivered at least three days before the withdrawal attempt, the CFPB said, and would include information about timing, amount, and channel of the forthcoming withdrawal. Withdrawals for a different amount, through a different channel, or at a different time would require additional notice. Withdrawal attempts would be capped at two straight unsuccessful attempts (including a debit returned unpaid or declined due to insufficient funds). Lenders would then need to obtain new and specific authorization from the borrower to make additional debits from the account.

The Bureau may end up expanding the proposed rule. Accompanying the proposal was a request for information (RFI) with the CFPB, announcing an inquiry into other potentially high-risk loan products and "risky" practices not specifically covered by the proposed rule. The Bureau asked for information about high-cost, longer-duration installment loans and open-end lines of credit, where the lender does not take a vehicle as collateral or gain account access. Comments about the sales and marketing practices of credit insurance, debt suspension or debt cancellation agreements, and other add-on products as well as practices such as loan churning, default interest rates, teaser rates, prepayment penalties, and late-payment penalties are also being sought by the agency.

To read the CFPB's proposal, click here.

To read the RFI, click here.

Why it matters

After multiple reports—on auto title loans and the impact of payday loans on bank fees, among others—and actions against payday lenders, the CFPB's proposed rule came as no surprise. While consumer advocates praised the proposed rule, it generated an equal amount of criticism. Chairman of the U.S. House of Representatives Financial Services Committee Jeb Hensarling (R-Texas) expressed concern that for struggling Americans, "the struggle just got harder," asking in a statement, "How many are going to lose this only option they may have? How many are going to have their utilities cut off or are going to lose their jobs because they can't get money to repair their car and go to work? … It's sheer arrogance to believe this Washington rule will help them."