Tens of millions of Americans are turning to high-cost loans that routinely carry interest rates of more than 400% for everyday expenses, such as paying their bills and covering emergency expenses. For many, those rates end up being just too high and lead to a seemingly endless debt cycle.
But that may soon change. This week, five members of Congress plan to introduce federal legislation that would ban these sky-high rates on a variety of consumer loans, including payday loans. Instead, the Veterans and Consumers Fair Credit Act in the House would cap interest rates at 36% for all consumers.
Rep. Glenn Grothman, R-Wis., and Jesus "Chuy" Garcia, D-Ill., are co-sponsoring the legislation in the House, while Sens. Sherrod Brown, D-Ohio, Jack Reed, D-R.I., and Jeff Merkley, D-Ore., are simultaneously introducing a parallel bill in the Senate. The bipartisan legislation is built off the framework of the 2006 Military Lending Act, which capped loans at 36% for active-duty service members.
Specifically, this week's legislation would extend those protections to all consumers, capping interest rates on payday, car title and installment loans at 36%. That's far lower than the current average 391% APR on payday loans calculated by economists at the St. Louis Fed. Interest rates on payday loans are more than 20 times the average credit card APR.
"We've already had a bill dealing with military personnel and military bases that's proved to be wildly successful," Grothman tells CNBC Make It. "If you just leave it there, it leaves you with the impression that we have to protect the military, but we'll let [payday lenders] run amok and take advantage of everyone else."
The payday loan landscape
Lenders argue the high rates exist because payday loans are risky. Typically, you can get these small loans in most states by walking into a store with a valid ID, proof of income and a bank account. Unlike a mortgage or auto loan, there's typically no physical collateral needed. For most payday loans, the balance of the loan, along with the "finance charge" (service fees and interest), is due two weeks later, on your next payday.
Yet consumer advocates have long criticized payday loans as "debt traps," because borrowers often can't pay back the loan right away and get stuck in a cycle of borrowing. Research conducted by the Consumer Financial Protection Bureau found that nearly 1 in 4 payday loans are reborrowed nine times or more. Plus, it takes borrowers roughly five months to pay off the loans and costs them an average of $520 in finance charges, The Pew Charitable Trusts reports. That's on top of the amount of the original loan.
"It's normal to get caught in a payday loan because that's the only way the business model works," Nick Bourke, director of consumer finance at The Pew Charitable Trusts, told CNBC Make It last year. "A lender isn't profitable until the customer has renewed or reborrowed the loan somewhere between four and eight times."
These loans are pervasive. More than 23 million people relied on at least one payday loan last year, according to financial research company Moebs Services. Across the U.S., there are approximately 23,000 payday lenders, almost twice the number of McDonald's restaurants.
Payday loans "saddle borrowers with interest rates that regularly top 600%, and often trap borrowers in a downward spiral of debt," Brown said in a statement about the new legislation. "We need to make it clear in the law — you can't scam veterans or any other Ohioans with abusive loans that trap people in debt," he added, referencing his home state.
Yet payday loans are an accessible option for those who may have poor or no credit that might not get approved by a traditional bank. Payday loans can also be cheaper than other credit options, such as overdrafts. If your bank assesses an average fee of $35 on an overdrafted purchase of $100, you're paying an APR of well over 12,700%. Keep in mind the median amount overdrafted is much less, about $40, Moebs reports. Plus, many banks will charge an overdraft fee for every purchase that hits while your checking account is overdrawn.
The controversy over payday loans
Payday lending and consumer loans are not a new phenomenon, and there are already federal and state laws on the books to help consumers. In fact, California passed new rules in September that block lenders from charging more than 36% on consumer loans of $2,500 to $10,000. This week's bills would not supercede the existing state infrastructure, Grothman says.
Payday loans, in particular, have been a hotly contested issue since the CFPB, the government agency tasked with regulating financial companies, first delayed implementation of Obama-era payday loan rules earlier this year that required lenders to ensure borrowers could repay their loans before issuing cash advances.
Since then, Democrats have attempted to drum up support to craft federal rules that would ban high-cost loans. Rep. Alexandria Ocasio-Cortez, D-N.Y., and Sen. Bernie Sanders, I-Vt., introduced new legislation in May taking aim at loans. They jointly released the Loan Shark Prevention Act, which would cap interest rates on credit cards and other consumer loans, including payday loans, at 15% nationally.
But this week's bill is the first with bipartisan support. "People shouldn't take out these loans, but the number of people who are financially illiterate is just too high in our society," Grothman says, adding that makes people "vulnerable to buying a bad product." And now is the time to put federal rules in place to change that, he says, as more and more of payday loan industry moves more online.
Yet supporters of law-abiding payday lenders say that capping the rates would make it difficult for storefronts to continue to provide these types of loans without collateral. Without these lenders, consumers may not have a lot of options if they need a cash advance. "The Federal Deposit Insurance Corporation experimented with a 36% loan cap, but reviews of that pilot program made clear that the loans simply weren't profitable enough for banks to continue offering the product," says D. Lynn DeVault, chairman of the Community Financial Services Association of America, which represents payday lenders.
"Small-dollar loans are often the least expensive option for consumers, particularly compared to bank fees — including overdraft protection and bounced checks — or unregulated offshore internet loans and penalties for late bill payments," DeVault said in a statement to CNBC Make It.
But consumer advocates say capping payday loan rates will not significantly impact consumers' ability to get cash. Many states already impose interest rate restrictions, and consumers have found other ways to address financial shortfalls, says Diane Standaert, director of state policy at the Center for Responsible Lending.
Ohio, which previously had the highest payday interest rates in the nation, implemented legislation in April that capped annual interest of these loans at 28% and barred auto title loans. While the number of lenders has dropped since the new rules went into effect, there are currently still 19 companies that hold licenses to sell short-term loans, with 238 locations, according to an NPR news affiliate based in Cincinnati.
Even if the bill doesn't get out of the Senate, Grothman is hopeful that the additional discussion and education will help people understand what they're getting into when they take out a high-interest loan.
"It's a shame when people work so hard for their money and then lose it, and really get nothing in return but a high interest rate," he says.