To see a television advertisement for a business offering payday loans (technically, "deposit-advance loans") is to see payday loans advertised as a lifeline: a way for a financially strapped family to cover an unexpected expense -- like repairing a car to get to work or fixing the furnace to get through winter.
But that's not actually how most payday loans are used. In fact, only 16 percent of first-time payday borrowers take out these loans to deal with a sudden, unexpected expense. Nearly 70 percent of those borrowers use the loan for a recurring expense, like rent, utilities, or food.
When you consider that most of these loans are taken out to cover monthly expenses -- yet only one in seven borrowers can afford to repay that average payday loan from their monthly budgets -- it's easy to see how loans that are billed as "lifelines" more often function as anchors, sinking borrowers into debt from which they cannot escape.
Today, the average payday borrower pays more than $500 in finance charges and spends five months in debt for the average $375 loan. Seniors and members of the military (because they tend to have steady income, from either Social Security or their salaries) are frequent targets for this type of lending.
To be clear, not all payday lending is predatory lending. Especially in this difficult economy, there is a significant need for small-dollar short-term credit, as evidenced by the fact that more than 12 million Americans take out payday loans every year, spending more than $7 billion on principal, interest, and fees.
But a study by the Consumer Financial Protection Bureau found that even reputable banks that offer products marketed with names like "Early Access" and "Ready Advance" often end up locking customers into arrangements that have them taking out an average of 10 loans per year, and paying over $450 in fees.
In 2010, the National Credit Union Administration (NCUA), which I chair, placed restrictions on this kind of lending by credit unions.
Last week (Nov. 20), two financial regulators (the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation) issued strong new restrictions on banks offering short-term, high-interest loans.
Those new regulations have caused an outcry from banks who argue that they are so restrictive, they will simply drive borrowers into the arms of less-regulated, less-reputable lenders.
I believe there is a workable solution to providing short-term credit in a way that protects consumers and is viable for financial institutions.
Tucked away in a corner of the Dodd-Frank Act is language authorizing demonstration programs (overseen by the Secretary of the Treasury) to provide low-cost, small loans that serve as an alternative to payday loans.
At NCUA, we took this authorization to establish a new rule and a new program that allows and encourages credit unions to create the right type of short-term small loans.
What does this reasonable alternative to high-cost payday loans include?
It allows borrowers to access between $200 and $1,000, provided they have been members of the credit union for at least one month.
It caps interest rates at 28 percent, a number that is a fraction of what predatory lenders charge, but high enough for credit unions to account for the higher risk associated with making this type of loan.
Unlike many payday lenders, who use exorbitant application fees to make money and offset risk, our program caps the application fee at $20, an amount that we feel is sufficient to recoup the actual cost associated with processing the application.
Loan terms can range from one to six months -- longer than the payback period of most payday loans. And credit unions are prohibited from rolling over these loans or making more than one loan at a time (or three in any rolling six-month period), a practice that often allows borrowers to become overextended.
Already, we're seeing credit unions offer products that meet these criteria, along with additional features to help borrowers break the payday loan cycle, like financial counseling or help in opening a savings account and building savings. And those that have are telling us that they are seeing much lower than expected delinquency rates.
As these consumers improve their credit, they begin to qualify for even lower-priced products, which will effectively increase their incomes.
With the right products and rules of the road, credit unions and other financial institutions can help millions of cash-strapped Americans break free of their reliance on expensive loans.
With the right payday loan alternatives, we can replace a cycle of debt and dependency with one that meets borrowers' short-term needs while promoting greater financial security in the long run.