CFPB just published its review of payday lending, auto title loans, and pawnshops. These three alternatives to the household use of credit cards aim at providing down-market borrowers with an option to stay afloat when the car breaks down, someone gets ill, or encounter another bump in the road.
The three options provide loans of “typically less than $1,000” for short durations, with high-interest rates. In contrast to credit cards, where research is standard, this niche receives little attention, and CFPB’s annual study adds value to understanding the market.
Despite good intentions, when people borrow at these hard-money lenders, they often carry short-term debt for a long time. They enter a trap because rates are so high, and their desperate intention to raise money did not end with a realistic conclusion.
The three loan types classify as alternative financial service items. Here is how they work in most cases.
Payday Lending: these are short-term loans secured by a postdated check. Interest rates are more than 40 times the average credit card rate in some states. In Texas, for example, the annualized interest rate is 644%, versus the average credit card APR of 16%. Some states forbid or cap the rates. Illinois, for example, currently permits a rate of 404%, but pending legislation seeks to limit it to 36%, which will likely end the lending practice. Florida allows 304%, and California permits 460%. Several states prohibit payday lending, such as Colorado, Massachusetts, New York, and Vermont.
Auto-Title Loans: carry interest rates that translate to about 300% per year, according to the Federal Trade Commission. With a baseline rate of 25% per month, lenders will typically permit loans between $100 and $5,500 for a short-term loan. According to the FTC, “You’ll need to present your car, the clear title, a photo ID, and proof of insurance to complete the transaction. Many lenders also require a duplicate set of car keys.”
Pawnshop Loans: average $150 and require the borrower to collateralize the loan with something of value. Rates are competitive with auto-title loans at 300% per year, and with nearly 12,000 pawnshops in the U.S., there is a wide range of accepted collateral types. The Hustle mentions “Wedding rings, shotguns, antique horse saddles, prosthetic limbs, and any electronic device imaginable” as options for this $6 billion industry.
Several issues surround these alternative borrowing channels. Interest rates are off the charts, as they carry three-digit interest requirements. You can complain about credit cards, but in the United States, you have about 5,000 options, from credit unions to traditional banks and aggressive non-banks.
The challenge with these alternative channels is that they are not one-and-done. It seems that once you enter the world of high-cost borrowing, it is like the roach motel. You can check-in, but you cannot check out.
According to the CFPB’s report, “Comparing across the two waves, 52 percent of consumers who had taken out a payday loan in the six months before June 2019 had also taken out a payday loan in the 12 months before June 2020. The corresponding numbers are 32 percent for auto title loans and 56 percent for pawn loans.”
The trend is similar to those who get stuck in the revolving credit trap, but their interest rates measure in double digits. From the same report, “For comparison, 81 percent of consumers who were revolving credit card debt in June 2019 were also revolving in June 2020.”
Embracing the fringes of credit is expensive because of the ensuing risk. Creditors must support their risk with higher interest rates if they are not selective with whom they lend. A well-scored account carries little credit risk. An unscored account or poorly scored account will have a higher risk, which is the proverbial credit trap.
Overview provided by Brian Riley, Director, Credit Advisory Service at Mercator Advisory Group