The Consumer Financial Protection Bureau (CFPB), a division of the government that advocates for economic guidelines that benefit consumers, announced in June 2016 that they were working on a plan to crack down on payday loans. In this, the CFPB’s proposed rules would require that lenders verify that potential borrowers can afford to pay off their loans. These regulations, according to the CFPB, would help low-income borrowers avoid falling into a spiral that leaves them further and further in debt from loan terms designed to encourage repeat borrowing.
If passed, these laws could reduce the potential danger of payday loans. But the market adapts to regulation, and installment loans could rise to fill the gap left by a diminished payday loan industry.
Predatory Installment Loans
Not all installment loans are financially risky. Installment loans are simply loans paid over a set period of time, such as a mortgage. Normally, these loans are not a viable substitute for payday loans. Predatory installment loans, however, could become a stand-in for payday loans.
Short-term installment loans are identified by extremely high interest rates (at 25% or greater) for small amounts (a few hundred to a few thousand dollars). Unlike payday loans, which usually have to be paid in full within 30 days, installment loans can be repaid over the course of months or years.
Currently, many types of installment loans would not be regulated by CFPB’s proposed set of rules.
The Risk for Borrowers
The high interest in predatory installment loans can cause consumers to pay the original amount of their loan many times over. Borrowers that simply make the minimum required payment would see the worst of this effect. Short-term installment lenders often target low-income borrowers that are more likely to stick to minimum payments, and these borrowers would be especially vulnerable to the effect of high interest rates.
Installment loans potentially keep borrowers in debt for much longer periods of time than payday loans, because payday loans are usually only for terms of 30 days.
Finally, high interest rates increase the probability that lenders profit even when borrowers eventually default. This reduces the incentive for lenders to fully vet potential borrowers for their ability to pay.
The Rise of the Installment Loan
Installment loans extended to borrowers with suboptimal credit nearly tripled between 2012 and 2015. And with payday loans potentially seeing more restrictions, installment loans could be poised to for a meteoric rise.
Some states — 11, in total — don’t impose a cap on interest rates for many types of small installment loans. These states in particular could see a meteoric rise of predatory installment lending.
The Counter-Argument
Advocates for payday and short-term installment loans say that high interest rates are necessary because these loans carry greater risk for default. They also argue that lower income borrowers need access to these loans because they have fewer options to meet their financial needs, and closing off this source of income will simply result in further hardship.
These arguments could be fair. But before you take out a small installment loan, do the math. If you can’t realistically make your payments, you could wind up defaulting on you loan, which can damage your credit and further restrict your access to loans with good interest rates. If you can make your payments, you could still be costing yourself thousands of dollars in interest and putting yourself in debt for years. If you consider these possibilities, the temporary relief of a loan could seem less attractive.
The results of the CFPB’s potential crackdown on payday loans remains to be seen. But installment lenders could have the opportunity to pick up where payday loans leave off. You may want to be sure you fully understand the short and long term effects of any loan before you sign on the dotted line.
Image: Antonioguillem
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