Short-Term, Small-Dollar Lending: Policy Issues and Implications
Released: 2017-06-14T00:00:00

Summary:
Short-term, small-dollar loans are consumer loans with relatively low initial principal amounts (often less than $1,000) with relatively short repayment periods (generally for a small number of weeks or months). Short-term, small-dollar loan products are frequently used to cover cash-flow shortages that may occur due to unexpected expenses or periods of inadequate income. Small-dollar loans can be offered in various forms and by various types of lenders. Banks and credit unions (depositories) can make small-dollar loans through financial products such as credit cards, credit card cash advances, and checking account overdraft protection programs. Small-dollar loans can also be provided by nonbank lenders (alternative financial service [AFS] providers), such as payday lenders and automobile title lenders.
The extent that borrower financial situations would be made worse from the use of expensive credit or from limited access to credit is widely debated. Consumer groups often raise concerns regarding the affordability of small-dollar loans. Borrowers pay rates and fees for small-dollar loans that may be considered expensive. Borrowers may also fall into debt traps, situations where borrowers repeatedly roll over existing loans into new loans and subsequently incur more charges rather than completely paying off the loans. Although the vulnerabilities associated with debt traps are more frequently discussed in the context of nonbank products such as payday loans, borrowers may still find it difficult to repay outstanding balances and face additional charges on loans such as credit cards that are provided by depositories. Conversely, the lending industry often raises concerns regarding the reduced availability of small-dollar credit. Regulations aimed at reducing costs for borrowers may result in higher costs for lenders, possibly limiting or reducing credit availability for financially distressed individuals.
This report provides an overview of the small-dollar consumer lending markets and related policy issues. Descriptions of basic short-term, small-dollar cash advance products are presented. Current federal and state regulatory approaches to consumer protection in small-dollar lending markets are also explained, including a summary of a proposal by the Consumer Financial Protection Bureau (CFPB) to implement federal requirements that would act as a floor for state regulations. The CFPB estimates that its proposal would result in a material decline in small-dollar loans offered by AFS providers. The CFPB proposal has been subject to debate. H.R. 10, the Financial CHOICE Act of 2017, which was passed by the House of Representatives on June 8, 2017, would prevent the CFPB from exercising any rulemaking, enforcement, or any other authority with respect to payday loans, vehicle title loans, or other similar loans. After discussing the policy implications of the CFPB proposal, this report examines general pricing dynamics in the small-dollar credit market. The degree of market competitiveness, which may be revealed by analyzing market price dynamics, may provide insights concerning affordability and availability options for users of certain small-dollar loan products.
The small-dollar lending market exhibits both competitive and noncompetitive market pricing dynamics. Some industry financial data metrics are arguably consistent with competitive market pricing. Factors such as regulatory barriers and differences in product features, however, limit the ability of banks and credit unions to compete with AFS providers in the small-dollar market. Borrowers may prefer some loan product features offered by nonbanks, including how the products are delivered, in comparison to products offered by traditional financial institutions. Given the existence of both competitive and noncompetitive market dynamics, determining whether the prices borrowers pay for small-dollar loan products are "too high" is challenging. The Appendix discusses how to conduct meaningful price comparisons using the annual percentage rate (APR) as well as some general information about loan pricing.

subsections: section_title: Introduction
paragraphs: Short-term, small-dollar loans are consumer loans with relatively low initial principal amounts (often less than $1,000) with short repayment periods (generally for a small number of weeks or months). Short-term, small-dollar loan products are frequently used to cover cash flow shortages that may occur due to unexpected expenses or periods of inadequate income. Small-dollar loans can be offered in various forms and by various types of lenders. Federally insured depository institutions (i.e., banks and credit unions) can make small-dollar loans via financial products such as credit cards, credit card cash advances, and checking account overdraft protection programs. Nonbank lenders, such as alternative financial service (AFS) providers (e.g., payday lenders, automobile title lenders), also provide small-dollar loans.
Affordability is a concern surrounding small-dollar lending. The costs associated with small-dollar loans appear to be higher in comparison with longer-term, larger-dollar loans. Furthermore, borrowers may fall into debt traps . A debt trap occurs when borrowers who may be unable to repay their loans reborrow (roll over) into new loans, incurring additional charges, rather than make progress toward paying off their initial loans. When individuals repeatedly reborrow similar loan amounts and incur fees that steadily accumulate, the rising indebtedness may entrap them into worse financial situations. Debt traps are frequently discussed in the context of nonbank products such as payday loans; but they may occur when a consumer makes only the minimum payment (rather than paying off the entire balance at the end of each statement period) on a credit card, which is an example of a loan product provided by depositories.
Borrowers' financial decisionmaking behaviors arguably must be carefully observed before concluding that frequent usage of small-dollar loan products results in debt traps. Determining how borrowers habitually get into cash flow (liquidity) shortages requires knowledge about their cash management practices and their perceptions of prudent spending and savings decisions. Policy initiatives to protect consumers from what may be considered expensive borrowing costs could result in less credit availability for financially distressed individuals, which may place them in worse financial situations (e.g., bankruptcy). The academic literature has not reached a consensus about whether access to expensive small-dollar loans contributes to or alleviates financial distress. Some academic research suggests that access to high-cost small-dollar loans improves well-being during temporary periods of financial distress but may reduce well-being if used for extended periods of time. Whether access to relatively expensive small-dollar loans increases or decreases the likelihood of bankruptcy is still debated.
Congress has taken some measures to address concerns related to small-dollar lending. For example, Congress passed the Credit Card Accountability Responsibility and Disclosure Act of 2009 (CARD Act; P.L. 111-24 ) in light of concerns that cardholders may be paying excessive credit card rates and fees, especially in cases where they are unaware of assessed penalty fees and interest rate increases. Congress also passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act; P.L. 111-203 ), which created the Consumer Financial Protection Bureau (CFPB). The CFPB was given the authority over both banking and nonbanking firms offering consumer financial products. The CFPB has subsequently implemented and proposed rules pertaining to small-dollar lending products. A recent proposed rule by the CFPB, which would implement federal requirements that would act as a floor for state regulations, would, among other things, require lenders to underwrite small-dollar loans to ensure borrower affordability unless the loan meets certain conditions. The CFPB estimates that its proposal would result in a material decline in small-dollar offerings by AFS lenders. The CFPB proposal has been subject to debate. H.R. 10 , the Financial CHOICE Act of 2017, which was passed by the House of Representatives on June 8, 2017, would prevent the CFPB from exercising any rulemaking, enforcement, or any other authority with respect to payday loans, vehicle title loans, or other similar loans.
This report provides an overview of the small-dollar consumer lending markets and related policy issues. It provides various small-dollar loan product descriptions, product usage information, and market metrics. The report also discusses current federal and state regulatory approaches to consumer protection in lending markets, followed by a summary of the recent CFPB proposal and policy implications. It then examines pricing dynamics in the small-dollar lending market. The degree of market competitiveness, which may be revealed by analyzing market price dynamics, may provide insights pertaining to affordability concerns as well as available options for users of certain small-dollar loan products. 
Using various industry profitability indicators, some research finds evidence of competition in the small-dollar (payday) lending industry. Other factors, however, would indicate that pricing is not necessarily competitive. For example, banks and credit unions face restrictions on permissible activities, which limit their ability to compete with nonbank small-dollar (e.g., payday) lenders. In addition, borrowers may prefer certain product features or delivery methods, meaning that they may be willing to pay a premium for some loan products relative to others. Given that small-dollar markets contain both competitive and noncompetitive price dynamics, determining whether borrowers pay "too much" for small-dollar loan products is challenging. These issues are discussed in more detail in the report. The Appendix describes how to calculate the annual percentage rate (APR) and provides information about general loan pricing.
section_title: Short-Term, Small-Dollar Product Descriptions and Selected Metrics
paragraphs:  Table 1 provides descriptions of various small-dollar and short-term lending products. Depository institutions typically provide products such as credit cards, overdraft protection, and installment loans. AFS providers typically provide small-dollar short-term credit products such as payday loans, auto title loans, and tax-refund anticipation loans. 
Small-dollar loan or cash advance products may be an expedient option during unexpected periods of income shortfalls, particularly for individuals lacking sufficient emergency savings as well as those with impaired credit. According to the Survey of Household Economics and Decisionmaking (SHED), conducted in October 2014 by the Board of Governors of the Federal Reserve System, approximately 25% of U.S. households experienced a form of economic hardship that may have resulted in a temporary disruption in income. According to a study released in 2012 by Pew Charitable Trusts, 69% of respondents used a payday loan (for the first time) to cover a recurring expense, such as rent, utilities, and other bills; and 16% of the respondents reported using a payday loan for unexpected expenses. 
Apart from credit cards, full (lump-sum) payment is normally expected when small-dollar loans are due. The costs of small-dollar loans may quickly escalate if they are repeatedly renewed because little or none of the initial principal amount is being repaid. The failure to make full and timely payments results in rollovers with additional interest charges on the outstanding principal balance and fees. Indebtedness levels quickly rise if borrowers repeatedly roll over their small-dollar loans.
The text box below contains information on average loan sizes and costs to use various small-dollar loan products. Short-term, small-dollar market aggregate data metrics vary in availability due to nonstandardized reporting requirements. Metrics can vary depending upon the definitions used when constructed (e.g., metrics can be computed with or without the inclusion of individuals who have outstanding balances; interest rates and fees can be reported separately or combined into a single metric). Data are also collected from different years and sources. Maturity lengths also differ among loan product types, raising questions about their comparability. Hence, comparing the relative costs of small-dollar loan products is challenging.
section_title: Overview of the Current Regulatory Framework and Proposed Rules for Small-Dollar Loans
paragraphs: Consumer lending is largely regulated for the protection of consumers and to ensure compliance with fair-lending laws. The regulatory framework for small-dollar lending involves different compliance regulators and different approaches, which apply to different products. A detailed assessment of the regulation of all small-dollar products is beyond the scope of this report, but broad observations of the consumer regulatory framework are discussed in this section.
Both bank and nonbank lenders are subject to federal consumer protection and fair-lending laws and regulations if they offer a credit (loan) product covered by those laws and regulations. The Consumer Financial Protection Bureau is a federal regulator that has the authority to issue regulations pursuant to most federal consumer financial protection laws that cover an array of consumer financial products and services.
Different lenders are supervised by different regulators. Depository institutions (i.e., banks and credit unions) having assets below $10 billion are supervised for consumer protection compliance by their prudential regulators. Banks are supervised by the federal prudential regulators, namely the Federal Reserve System, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC). The federal prudential regulator of credit unions is the National Credit Union Administration (NCUA). Depository institutions having assets above $10 billion are supervised for consumer protection compliance by the CFPB. Banks and credit unions may also receive state charters and may face additional regulations at the state level, but they would still be required to comply with federal prudential regulations if their deposits are federally insured. Depositories with national charters are generally exempt from additional state consumer regulations, but there may be exceptions for certain circumstances. Financial firms that offer consumer products and do not have national or state bank or credit union charters will be referred to as nonbank lenders in this report. Nonbank lenders include many AFS providers, such as payday and auto-title lenders, and they may be supervised by the CFPB or state financial regulators. 
subsections: section_title: Approaches to Small-Dollar Regulation
paragraphs: Different approaches are used to regulate small-dollar products, including disclosure requirements; usury laws; product-feature requirements; underwriting requirements; and unfair, deceptive, or abusive acts or practices (UDAAP) requirements. Disclosure laws are a form of consumer protection designed to ensure that borrowers are aware of the costs of their loans. The Truth in Lending Act (TILA; P.L. 90-321), passed in 1968, is currently implemented by Regulation Z. TILA applies to nearly all forms of consumer credit and requires covered lenders to disclose the total cost of credit, which includes both the loan rate and fees, in the form of the annual percentage rate (APR). TILA is not a usury law, meaning that it does not regulate what lenders may charge for loans. TILA does not apply to business loans. Financial institutions operating in certain states may face additional state disclosure requirements.
Usury laws are another form of consumer protections broadly designed to cap or limit the amount of interest that can be charged on loans. Usury laws are frequently promulgated at the state level, meaning that loan originations are subject to the caps in the applicable state; some states have multiple usury rates that apply to different forms of credit. The National Consumer Law Center reports that the Uniform Small Loan Laws, which place caps of 36% to 42% per year on loans of $300 or smaller, were adopted in 34 states over 1914-1943 to encourage lenders to make small-dollar loans and ultimately reduce widespread loan sharking. 
There is no federal usury limit for short-term, small-dollar loans, and federal law expressly prohibits the CFPB from establishing usury limits. Congress, however, did pass legislation capping both the interest rate and the fees, or the APR, for consumer loans offered to military personnel. The Military Lending Act of 2006 (MLA; P.L. 109-364 ) was passed to protect active duty military personnel and their eligible family members from predatory lending. The final rule implementing the MLA in 2007 required that payday loans have terms of 91 days or less; that vehicle title loans have terms of 181 days or less; and that short-term small-dollar loans to military personnel be limited to a 36% annual interest rate, which is known as the military APR (MAPR). On July 22, 2015, the Department of Defense announced final rules to extend the MAPR to a wider array of credit products, which includes credit cards. As of October 3, 2016, lenders receive safe harbor protection if they verify whether a consumer is eligible for the MLA protections by using information provided by the MLA database maintained by the Department of Defense. As of October 3, 2017, the MAPR will apply to credit card products offered to military servicemembers. 
Consumer protection regulation may exist in the form of substantive product feature requirements or restrictions . For example, some states ban certain types of lending and impose other restrictions. Payday lending is currently permitted in 38 states, and some states apply limits to or altogether prohibit rollovers. As an example of federal product feature restrictions, in 2009 Congress passed the Credit Card Accountability Responsibility and Disclosure Act (CARD Act; P.L. 111-24 ), which protects credit card and overdraft users from products with features that automatically recalculated and applied additional finance charges using complex methodologies that borrowers, who were likely to extend their loans, may not have been able to understand. 
Underwriting and UDAAP are also forms of consumer protection regulation. Underwriting regulations can require lenders to verify specific documents or consider other factors when underwriting applicant credit requests. The CFPB issued a proposed rule that could establish federal underwriting requirements for small-dollar loans, which is discussed in the next section. The CFPB has the broad authority "to prescribe rules declaring certain acts or practices to be unlawful because they are unfair, deceptive, or abusive." For example, the CFPB used its UDAAP authority to issue a bulletin related to the marketing and sale of "add-on" products with credit cards (e.g., debt protection, identity theft protection, credit score tracking) that are supplementary to the credit provided by the card itself. The CFPB provided guidance for institutions to avoid harming consumers when offering products with add-on features. 
section_title: Overview of the CFPB-Proposed Rule
paragraphs: The CFPB was established by the Dodd-Frank Act to implement and enforce federal consumer financial law while ensuring consumers can access financial products and services. Although its regulatory authority varies by financial entity types, the CFPB generally has regulatory authority over providers of an array of consumer financial products and services, including short-term, small-dollar payday lenders. 
On June 2, 2016, the CFPB released a proposed rule that would establish minimum requirements on small-dollar lending, including underwriting requirements for lenders. The CFPB states that the rule's primary purpose is to end payday debt traps. The CFPB considers loan payments to be unaffordable if borrowers have only three options when unable to repay the full amount due: (1) default on the loan, (2) take out an additional loan, or (3) make the loan payment while failing to meet other major financial obligations or basic living expenses. The comment period closed on October 7, 2016.
The CFPB proposal would establish at the federal level a floor for consumer protection requirements, covering loans lasting 45 days or less, such as payday loans, auto-title loans, and direct deposit advances. In addition, loans for more than 45 days in which the cost of credit exceeds 36% and the lender has a security interest (e.g., the ability to repossess a borrower's vehicle if the loan is not repaid, or access to a paycheck or a checking account) would be covered. The rule would exclude loans solely for the purchase of durable goods, mortgage loans, credit card loans, student loans, overdrafts, and pawnshop loans. The rule would apply to all lenders of covered products. Some of the specific requirements follow.
The Full-Payment (Ability-to-Repay) Test for Covered Short-Term Loans. All lenders would be required to consider and verify the borrower's income, the timing of the income, major financial obligations, and borrowing history using information from at least one credit bureau. Lenders would be required to ensure that borrowers can pay off their loans and all finance charges without having to reborrow for a proximate 30 days. Borrowers would be unable to reborrow or refinance the same amount of debt, and the total number of successive short-term loans would be capped. A lender would not be able to make a loan to a consumer who already has taken three loans within 30 days of each other. Alternative Compliance Option for Covered Short-Term Loans. For lenders who prefer not to meet the full payment test, the rule includes an alternative compliance option that stipulates required loan features. A lender would still be able to make loans up to $500 without underwriting if the borrower does not have any other outstanding short-term loans or loans with balloon payments. Borrowers would be allowed to have up to two extensions as long as at least one-third of the principal balance is repaid with each extension. The lender would still be required to confirm that a customer does not have outstanding loans with other lenders, and the customer would not be permitted to have any more than six loans over a consecutive 12-month period. Alternative Compliance Option 1 for Longer-Term Loans. Lenders would be allowed to make loans (without meeting the ability-to-repay requirement) that meet criteria established by the National Credit Union Administration for the payday alternative loan (PAL) product that may be offered by credit unions. The interest rate permitted for credit unions is currently 28%, with an application fee of no more than $20. Alternative Compliance Option 2 for Longer-Term Loans. Lenders would be allowed to make loans (without meeting the ability-to-repay requirement) that meet the following criteria: The maturity of the loan must be a minimum of 46 days, up to a maximum of 24 months. The APR may not exceed 36%, and the origination fee cannot exceed $50. In addition, lenders must refund all origination fees collected on these loans if the default rate on all such loan types held in their portfolios exceeds 5%. Advance Notice to Borrowers When Collecting Funds Owed . When collecting funds owed, small-dollar lenders would be required to give advance notice to borrowers before attempting to debit payment from their depository checking, savings, or prepaid accounts. After two consecutive attempts to collect payment, a new authorization would be required from the borrower before the lender could make another attempt to collect payment. 
section_title: Policy Issues
paragraphs: Borrowers' total charges associated with payday loans are presumed to be expensive especially in light of triple-digit APRs. An understanding of price dynamics in the small-dollar lending markets may shed light on the degree of market competitiveness, which may in turn inform the policy debate about the affordability and available options for consumers who use these loan products. A market is considered competitive when a sufficient number of firms exist such that no individual firm has the ability to set prices significantly above the costs to supply the product, as they would risk losing market share to competitors. The small-dollar lending markets exhibit both competitive and noncompetitive market pricing dynamics; consequently, determining whether the prices borrowers pay for their loans are "too high" is challenging. These issues are discussed in more detail below after a discussion of the implications of the CFPB-proposed rule, which also focuses on affordability.
subsections: section_title: Implications of the CFPB-Proposed Rule
paragraphs: The CFPB maintains that financial injury to borrowers occurs when lenders make unaffordable loans. The CFPB collected data indicating that 37% of the average payday borrower's biweekly paycheck would be required to repay both principal and finance charges in full; and 49% of the average vehicle-title borrower's biweekly paycheck would be required for full repayment. The CFPB found that small-dollar loans offered by payday and vehicle-title lenders were advertised as short-term solutions, and borrowers were not made aware that frequent rollovers could transform the loans into longer-term obligations. Requiring more disclosures about the possible financial harm associated with reborrowing may have been one approach employed to protect consumers; however, the CFPB chose to require lenders to consider loan affordability. 
Underwriting loans for affordability generates costs for lenders. Automated underwriting refers to a computerized scoring method typically used when evaluating and pricing credit for higher-credit-quality borrowers. The CFPB estimates that the costs of complying with the proposed rule may not be large for lenders that already underwrite their loans, particularly for those already engaged in automated underwriting. By contrast, manual underwriting is a labor-intensive method of evaluating and pricing credit for borrowers with impaired credit who cannot be priced using automated underwriting. Payday lenders, therefore, would likely incur large costs to comply with the rule, given that their customer bases frequently include larger shares of individuals with weak or invisible credit histories. Payday lenders typically do not underwrite for default risk and, therefore, may need to increase staffing to administer relatively more expensive manual underwriting. In addition to verifying income, manual underwriting costs would include estimation or verification of major financial obligations (e.g., housing expense, child support, current delinquencies, some recurring expenses), and perhaps costs to investigate information related to borrowers' extenuating circumstances. 
The CFPB estimates a 55% to 62% decrease in the number of small-dollar loans offered by AFS providers and a decrease in their revenue of 71% to 76%. A study commissioned by the AFS industry also predicts a large market contraction, closer to an 82.5% decrease in small-dollar loan offerings. The CFPB anticipates that, in light of the higher underwriting costs, many AFS lenders are likely to choose the alternative compliance option for covered s hort-term loans. The CFPB maintains that contractions in the small-dollar loan market, therefore, would be largely due to fewer rollovers, thus benefiting consumers by having fewer opportunities to default and get into worse financial situations. Conversely, the industry maintains that the small-dollar market contraction would likely result from the inability of lenders to recover compliance costs. The typical payday loan of $500 or less is unlikely, the industry argues, to generate a sufficient yield to justify incurring the additional costs to perform manual underwriting. Furthermore, some individual AFS lenders (e.g., storefront lenders) may lack sufficient loan volume to cover the additional underwriting, documentation, and verification expenses. Hence, the industry maintains that borrowers are likely to experience unmet credit needs or be forced to use less preferable loan products. 
In anticipation that the CFPB's proposed rule is finalized, AFS providers have increased offerings of medium- and longer-term installment loans. An installment loan is a closed-end loan, meaning that it must be repaid in regular installments at the end of a preset period. Installment loans are preapproved for a specific amount, and the borrower does not have the option to redraw any funds that have been repaid over the life of the loan. An installment loan may have a term of 6 months to 12 months; such a loan is thus considered a medium-term rather than a short-term consumer loan. The repayment of debt obligations in regular installments, which allows for principal amortization and smaller regular payments, may arguably be a preferred alternative to reliance upon sequences of short-term rollovers for some borrowers. In contrast, some borrowers may still prefer smaller loans with the option to determine how many times to roll them over, which they may consider to be preferable product features (discussed in the " Challenges Comparing Relative Prices of Small-Dollar Lending Products " section) or allow for the opportunity to reduce total costs in some circumstances (discussed in the Appendix ). 
section_title: Competitive and Noncompetitive Market Pricing Dynamics
paragraphs: As previously mentioned, affordability is a central issue in the debate surrounding small-dollar loans, with some pointing to high prices (i.e., APRs) as evidence. The state of being expensive, however, is subjective, which is why economists consider the degree of market competitiveness for additional context. A market is considered competitive if individual firms lack the ability to set prices higher than their competitors, meaning that they would likely lose market share by pricing their products too aggressively. Luxury goods (e.g., cars, fashion, travel, entertainment), for example, may be unaffordable for some consumers, yet luxury good providers may still be forced to price their products competitively to maintain the business of consumers who may still aggressively shop for the best price. Likewise, evidence of competition in the small-dollar loan market may indicate that even though prices appear expensive, they are more likely to be driven closer to the lenders' costs to provide the loans and less likely to reflect large markups above costs. Conversely, prices may reflect markups in less competitive markets. 
Some research has found evidence of competitiveness in the payday lending industry such that pricing appears to be commensurate with costs. The leading expenses incurred by AFS lenders were wage costs, occupancy costs (e.g., rents), and loan loss rates. Payday lenders were found to have double-digit loan loss rates (in comparison to banks over the same period, with loss rates below 2% on all outstanding loans), which diminish profitability. Industry profitability was found to be highly dependent upon volume and loan-loss rates. For this reason, rollovers increase loan volumes but simultaneously increase loan-loss-rate risks. Additional academic research found that the risk-adjusted returns at publicly traded payday firms were comparable to those of other financial firms. Hence, recent research was unable to show that current pricing practices generate revenues for payday firms at levels significantly higher than costs.
Other evidence is consistent with some noncompetitive pricing practices. Price collusion, for example, refers to an explicit or implicit collaboration by industry firms to charge similar prices. The existence of state usury ceilings may facilitate implicit price collusion behavior among AFS providers, which would be consistent with a behavioral response predicted by economic theory. Hence, research has found that many payday lenders charge the maximum usury rates allowed in a state even though some firms might be able to offer their loan products for lower costs. Usury caps may incentivize firms to set their prices at usury ceilings because any evidence of uniform and unlawful price fixing among competitors, given that caps theoretically are set below free-market prices, is arguably more concealed. 
Because the small-dollar loan market reflects both competitive and noncompetitive pricing dynamics, other factors that affect competition in this market are further examined. Permissible activities as well as borrower preferences for certain product features are likely to have some influence on small-dollar loan pricing.
subsections: section_title: Permissible Activities of Depositories
paragraphs: Depository institutions face various restrictions on their permissible activities that may limit their ability to offer small-dollar loan products similar to those offered by AFS providers. For example, a subprime (fee harvester) credit card is one in which the total fees amount to a large proportion of the credit limit, making it similar in characteristics to a payday loan. Depositories offered subprime credit cards to people with impaired credit, meaning that they posed a higher probability of default risk relative to more creditworthy customers. The CARD Act mandates that the total fees of subprime credit cards cannot exceed 25% of the initial credit limit. The fee cap on subprime credit cards arguably may limit a loan product option for borrowers unable to qualify for traditional revolving credit, thus curtailing some ability of depositories to compete in the subprime small-dollar credit market with AFS providers.
Federal banking regulators expressed concern when banks began offering deposit advance products due to the similarities to payday loans. On April 25, 2013, the OCC, FDIC, and Federal Reserve issued final supervisory guidance regarding the delivery of these products. The prudential regulators expressed concerns that the high costs and repeated extensions of credit could add to borrower credit (default) risks. The guidance recommended that customers with impaired credit should not be eligible for this product, each deposit advance should be repaid in full before extension of a subsequent advance loan, and no more than one loan may be offered per monthly statement cycle. Most banks subsequently discontinued offering deposit advances.
Similarly, the ability of the credit union system to compete in the small-dollar loan market depends upon regulatory requirements. The portion of the small-dollar lending market that credit unions can potentially serve is limited due to membership restrictions. In addition, the credit union system is permitted to make payday alternative loans (PALs) to its membership, but these products are different from traditional payday loans. PALs typically have longer maturities in comparison to AFS products and, therefore, lower APRs. The CFPB argues that PALs protect consumers because the interest rate is no greater than 28% and the application fee is no greater than $20. Despite the relatively lower total borrower costs, the NCUA requested an exemption from the 36% MAPR for PALs to avoid lending reductions to military service customers by credit unions.
In short, limitations on permissible activities may affect the extent to which mainstream depositories can compete with AFS providers. According to a 2015 survey of 132 community banks, 39% of them reported making personal loans under $1,000 (i.e., survey definition of small-dollar) for less than 45 days (i.e., survey definition of short-term). Another survey found that in 2014, banks offered only 1% of small-dollar loans for $500 or less (with maturities for 30 days or less). Because banks and credit unions are required to adopt loan underwriting standards, depositories generally offer products with longer maturities that facilitate the recovery of compliance costs. Hence, the regulatory differences between mainstream depositories and AFS lenders may prevent full-scale competition between these types of lenders in the small-dollar loan market. 
section_title: Challenges Comparing Relative Prices of Small-Dollar Lending Products
paragraphs: In addition to regulatory factors, consumers may pay less competitive prices under circumstances when product comparisons cannot be made solely on the basis of relative prices. Product price comparisons may be difficult when total fees, loan amounts, and maturities are not equal. Furthermore, borrowers may have strong preferences for certain product features even if they are more expensive. These issues are discussed below. 
When choosing a small-dollar loan product, the ideal comparison for a potential borrower would consist of (1) the prices of two loans of the same type (e.g., two payday loans) or (2) the prices of one type of small-dollar product with its next-best alternative. In light of TILA disclosure requirements, the APR would be deemed the key metric for such comparisons. The mathematical relationships (discussed in the Appendix ) show that small-dollar loans, all else equal, will always have higher APRs in comparison to loans for larger amounts; and loans with maturities of less than one year, all else equal, will always have higher APRs in comparison to loans with maturities equal to or greater than one year. For these reasons, APR comparisons are meaningful when loans are of similar amounts and have similar maturity lengths. 
However, making ideal comparisons is not always possible. Even slight differences in product pricing and maturities increase the difficulty of comparing costs. For example, suppose a borrower is trying to decide whether to use a bank overdraft product or a payday loan. Banks are allowed to set their own overdraft policies. Some banks may charge a fixed fee for each overdraft regardless of the amount borrowed, whereas others have a tiered pricing structure as the amount of the loan increases. Some banks require repayment sooner than the two-week period typically associated with a payday loan; other banks may allow slightly longer repayment periods, such as 30 days. For this reason, the variances in pricing structure and maturities make APR comparisons problematic, not only for comparisons of small-dollar products across lender types, but also for comparisons among the same type of lenders (e.g., different banks).
In addition, making loan comparisons based solely on product prices may not be possible if borrowers have strong preferences for certain product features or place value on the conveniences associated with the products. Under such circumstances, prices may reflect more specialized market segmentation. The situations below illustrate when borrowers may place greater weight on nonprice factors relative to the total loan price. 
Some borrowers may not find the APR to be a useful disclosure. Interpreting APRs may not be widely understood, and some users of small-dollar loans report that the flat-fee pricing structure of AFS credit providers is easier to understand in comparison to banks' fee structure disclosures. Furthermore, some borrowers facing cash flow shortages may value the actual dollar cost of credit rather than the APR. Borrowers may consider factors pertaining to product delivery, such as the convenience of locations and business hours or the length of the application process. The FDIC reported that some (unbanked) individuals chose AFS lenders because they viewed the process of applying for small-dollar credit to be easier than applying for credit at traditional depository institutions, and they feel that banks do not provide small-dollar loans (e.g., loans for less than $500 or, more broadly, for $1,000). Hence, borrowers may be willing to pay premiums for the expediency and ease of obtaining credit from AFS lenders. Reportedly, the increase in usage of AFS products by millennials as well as by middle- and high-income individuals may partly reflect preferences for convenience. Borrowers may consider how using depository products, such as credit cards, might affect their credit scores. For example, some borrowers' decisions to use a bank or AFS product would not depend solely upon an APR comparison if they consider how factors such as their credit utilization rates (i.e., the amount of outstanding debt relative to a credit card limit) may affect their credit scores. Some borrowers may ascribe their own functionality to certain product types. For example, when given the choice of using a credit card or payday loan, some borrowers may prefer using credit cards on a regular basis and payday loans for emergencies; others may prefer to use credit cards sparingly to ensure having access to a line of credit for emergencies. For instance, the function of a loan product may depend upon how borrowers have formed their perceptions of how to access credit. 
In short, both price and nonprice factors influence product choice, meaning that some customers may be willing to pay a premium in some instances for loans that provide them with unique (nontraditional) or convenience features. Survey respondents, however, are seldom asked how much value they place on the APR versus the total dollar amount, maturity lengths, and convenience of delivery when choosing between bank and AFS products. Furthermore, little information is known about the nature of relationships with mainstream institutions that current users of AFS products had or may still have. Hence, the prices borrowers are willing to pay arguably may reflect the relative scarcities resulting from the limited availability of products with features or delivery methods they may prefer. For this reason, determining whether the prices borrowers pay for small-dollar credit are "too high" is arguably challenging. 
subsections: section_title: Appendix. Understanding the Annual Percentage Rate (APR)
paragraphs: This Appendix explains how the APR is computed and summarizes the mechanics of loan pricing, thus explaining why it may be difficult to conclude that small-dollar loans are less affordable than larger loans by relying solely on the APR metric. 
The APR represents the total annual borrowing costs of a loan expressed as a percentage. The APR is calculated using both interest rates and origination fees. For the most part, the APR may be calculated using the following standard formula:
APR= [(INTFEES)/(LNAMT)]*(365/DAYSOUT)*100, where
INTFEES=Total interest and fees paid by the borrower;
LNAMT=Loan amount or total borrowings; and
DAYSOUT= Number of days that the loan is outstanding (term length).
The formula shows that the APR rises due to increases in interest and fees paid by the borrower, which is determined by both demand and supply factors discussed in the below text box. Borrowers may ask lenders to disclose the interest rate and fees separately, which may be helpful for negotiating the costs of each component separately, but borrowers are likely to care more about the total costs they must pay in comparison to other competing offers. Furthermore, it is not possible to ascertain from looking solely at the interest and fees paid whether higher supply-side costs (e.g., costs to acquire the funds or to process the loans) or higher demand-side factors (e.g., volume of customers, lack of feasible options for prospective borrowers) had a greater influence on the negotiated APR.
The formula shows that the APR is inversely related to (1) the loan amount (LNAMT) and (2) the length of time the loan will be outstanding (DAYSOUT). If interest and fees (INTFEES) are held constant, a small-dollar (payday) loan expected to be repaid in 30 days or less (in a single balloon payment) would have a higher APR relative to a larger loan, in which the repayment of principal and total charges occur over a longer period of time in multiple installment payments. Thus, the interpretation of the APR for loans originated for less than 365 days has been debated. An APR based on a term length of one year or greater accurately reflects the annual cost of credit. By contrast, an APR for a loan expected to be repaid in less than 365 days, such as a deposit cash advance or payday loan with term lengths of 30 days or less, is arguably overstated. 
Furthermore, APR comparisons are easier to interpret when the loans' maturity lengths are identical. A comparison of two payday loans with identical two-week maturities would be meaningful even though both APRs would likely be in the triple digits; a comparison of loans with identical medium- or longer-term maturities also would be meaningful. In contrast, APR comparisons of loans with different maturities, such as APR comparisons of a 30-day payday loan to a loan with a maturity of at least 365 days, would be misleading. The APR of the longer-term loan will mathematically be lower, and the interest and fees paid by borrowers could possibly be higher, reflecting increases in the loan amount or the number of days the loan is outstanding. 
 Table A- 1 provides examples of the estimated costs to borrowers of various short-term loans and installment loans. Suppose borrowers are charged $15 on every $100 borrowed, or $150 on Payday 1 and $75 on Payday 3 for $500; both loans would have an APR of 391%. Payday 2 has been set to 36% to illustrate the impact of implementing a price cap. In this case, the borrower would pay $13.80 in interest and fees for Payday 2. Under all lending scenarios, lenders would profit when the costs to fund and deliver the loan products are sufficiently below what borrowers pay. Hence, the total costs must be sufficiently lower than $13.80 for Payday 2 to be profitable; otherwise, a lender arguably would seek relatively more profitable lending opportunities, including the installment loan discussed below. 
The comparison between a payday and an installment loan shows a trade-off between total loan costs (assuming no rollovers) and affordability (time to repay). If the borrower obtained an installment loan with the APR set at 36% for an entire year, the total cost would be $360 on a loan for $1,000. Assuming the borrower did not roll over Payday 1, the total cost would be less than the total cost associated with the installment loan. The installment loan, however, gives the borrower more time to repay the higher costs, which arguably may be more affordable. 
Borrowers who are unable to qualify for depository installment loans may have used sequences of payday loans as a substitute for installment credit. For illustrative purposes, Table A- 1 provides an example of a payday loan for $500 with $75 in total costs for comparison to the $1,000 installment loan. Suppose a borrower obtains Payday 3 and rolls it over five times for a total cost of $375. The total cost of Payday 3 with the sequences of rollovers would arguably approximate the total cost of the installment loan. The borrower has less time to repay the small-dollar loan in full to avoid the accrual of more charges, which arguably makes Payday 3 more expensive (also depending upon the number of rollovers). Nevertheless, a borrower unable to obtain installment credit from a depository institution or facing a time constraint may be willing to pay the higher charges associated with Payday 3. Hence, regulations that encourage lenders to substitute away from small-dollar loan products and into medium- and longer-term loan products (i.e., increase LNAMT and DAYSOUT) may not significantly reduce the total costs borrowers would incur by taking out a payday loan with additional (or the average number of) rollovers.