Consumer Credit Protection

Background

The Consumer Financial Protection Bureau (CFPB) now enforces most of the federal laws that protect consumers when they obtain credit. These include:

  • the Equal Credit Opportunity Act, which protects consumers from discriminatory credit practices, including age discrimination;
  • the Fair Credit Billing Act, which protects consumers in billing disputes;
  • the Fair Credit Reporting Act (FCRA), which grants consumers access to and input into their credit files;
  • the Fair Debt Collection Practices Act, which protects consumers from the unscrupulous and unreasonable tactics of debt collection agencies, including law firms and lawyers that regularly engage in the collection of debts but does not safeguard against the in-house collection activities of the original creditor; and
  • the Truth in Lending Act, which requires accurate disclosure of a loan’s annual percentage rate (APR) and the total dollar amount of the finance charge.

Nearly all states have usury and small-loan laws that limit the interest rates lenders can charge. Typically, states have capped small loan rates at 24 percent to 48 percent APR and have required installment repayment schedules. However, 32 states have put in place safe harbors for payday lenders, which permit payday loans at triple-digit interest rates. These high-cost loan products churn consumers through a cycle of debt, collecting high fees for extended periods with associated long-term harms such as increased difficulty paying bills, delayed medical spending, involuntary bank account closure, and increased likelihood of filing bankruptcy. Fourteen states and the District of Columbia have enacted laws to reduce the high costs and long-term negative effects of payday loans by effectively enforcing rate limits of about 36 percent APR. Four more states have enacted more limited reforms that limit the payday loan cycle of debt. Twelve million Americans take out payday loans each year spending more than $7 billion on loan fees alone. As of 2016, there were more than 22,000 payday loan storefronts lending $46 billion a year. A 2013 CFPB study found that 92 percent of payday loan applicants had annual incomes of $50,000 or below.

Some states allow lenders to use a mathematical formula known as of the “Rule of 78s” to estimate refunds of prepaid interest and insurance charges when a loan is repaid early. Using the Rule of 78s results in a smaller refund to the borrower. Federal law prohibits use of the Rule of 78s, but it exempts non-real estate finance company loans with terms of less than 61 months. This exemption effectively negates this protection for most consumer loans.

In addition, decades ago the US Supreme Court dealt a serious setback to borrowers’ ability to challenge interest rates when the loan transaction involves a national bank. In a landmark 1978 case (Marquette National Bank of Minneapolis v. First of Omaha Service Corp.), the court ruled that under the National Bank Act, national banks can charge the interest rate allowed by their home state to borrowers who live in states with lower interest rate limits. The Dodd-Frank Wall Street Reform and Consumer Protection Act did not affect this ruling.

The Fair and Accurate Credit Transactions Act of 2003 substantially amended the FCRA and contains additional consumer provisions. Under the law, all consumers may obtain one free copy of their credit report every year from each of the three national credit bureaus. This is important because credit scores are increasingly used to evaluate consumer credit risk and are a significant factor in determining whether a consumer obtains credit, how much credit is made available, and what the terms are.

Industry sources, in fact, estimate that credit scores are a determining factor in 90 percent of all consumer credit decisions in the US. According to a 2014 study by the Consumer Federation of America, consumers are fairly knowledgeable about credit scores. For example, more than 80 percent of respondents knew that credit scores were used by mortgage lenders (87 percent) and credit card issuers (88 percent) and that missed payments (92 percent) and high credit card balances (87 percent) can affect a score. However, only 42 percent knew that credit scores measure the risk of not repaying a loan rather than knowledge of—or attitude toward—consumer credit.

Consumers must be able to ensure their credit reports are accurate. Because not all creditors report data to credit-reporting agencies, relevant credit information may not be included in the reports.

Alternative financial services—the alternative financial services (AFS) industry is a major source of credit services for consumers of low and moderate incomes, residents of neighborhoods with racial and ethnic groups that have experienced discrimination, and people with heavy debt burdens or less favorable credit histories. It includes payday lenders, pawnbrokers, car-title lenders, rent-to-own stores, and tax preparation companies that make loans on the basis of anticipated tax refunds.

The use of AFS transactional and loan products is increasing among US households. In its 2015 survey of unbanked and underbanked households, the Federal Deposit Insurance Corporation (FDIC) found that one in four households had used at least one AFS product in the prior year. The FDIC also found that unbanked households were much more likely than banked households to use an AFS product in the past year—57 percent of unbanked households used an AFS product compared with 21 percent of banked households. Generally, the industry lies outside the system of federally-insured traditional financial lenders, and its fees are often many times higher than those of traditional lenders. The deceptive and unfair lending practices often associated with the industry include hidden fees, exceedingly high interest rates, prepayment penalties, extreme default penalties, packing expensive credit insurance onto loans, and multiple rollovers. The AFS industry is now subject to regulation by the CFPB.

According to the 2013 Federal Reserve Board Survey of Consumer Finances, 7 percent of all families did not have a transaction (checking, savings, or money market) account. Eight percent of families headed by people age 50 and older did not—approximately 4.1 million older families.

Custom analysis of a 2008 survey of unbanked and underbanked consumers shows that among people age 45 and older, African-American and Hispanic people were more likely to be unbanked than whites. Similarly people with household incomes of $25,000 or less were more likely to be unbanked than those with incomes over $25,000. The survey shows that although people age 45 and older consistently prefer to use a bank or credit union for financial transactions, a number rely on check-cashing outlets, payday lenders, car-title lenders, rent-to-own stores, and other AFS entities to cash checks, pay bills, secure loans, and make purchases.

Some companies have begun offering a pension advance—a lump-sum loan provided to a pensioner in exchange for receiving a specified number of payments, or sum, from the pensioner’s future pension payments for a given period of time. The payments also include fees related to the loan. A related product, the pension investment, bundles advance pension payments in exchange for an up-front lump-sum investment. Federal law does not specifically regulate either pension advances or pension investments, though general protections against unfair, deceptive, or abusive act and practices may apply to these financial products.

Another form of alternative financial services is so-called peer-to-peer lending. Peer-to-peer lending platforms connect individual borrowers with individual lenders. They appeal to investors by advertising attractive returns in a low-interest-rate environment. They attract borrowers interested in obtaining small-dollar loans for purposes as varied as consolidating debt, paying off medical bills, and covering small business expenses by advertising an alternative to traditional loans from banks or other depository institutions with low fixed rates.

Peer-to-peer lending platforms are loosely regulated and generally are not required to evaluate a borrower’s ability to repay a loan. Some lending platforms equate the ability to deduct payments directly from a borrower’s bank accounts with the ability of a borrower to repay a loan. However, this practice is not necessarily indicative of a borrower’s ability to repay a loan, as borrowers may be required to take on additional loans to cover any shortfalls generated by such withdrawals.

A meaningful evaluation of the ability to repay a loan requires platform companies to consider the ability of borrowers to repay their loan while meeting other expenses. Peer-to-peer lending platforms use so-called black box or secret sauce algorithms to underwrite loans and obtain leads. These can circumvent traditional underwriting best practices. In addition, since peer-to-peer platforms rely on data brokers for referrals, borrowers may be directed to loans that generate the highest referral yield for a data broker rather than the most favorable terms for repayment of a loan.

Despite the apparent novelty of peer-to-peer lending platforms, they are essentially a rebranding of debt securitization. Rather than marketing debt instruments primarily to institutional investors, these platforms create an online marketplace in which any individual may buy debt instruments, not just professional investors. Although there is nothing inherently wrong with offering such debt instruments to the public at large, it is unlikely that the majority of individual investors have the financial sophistication required to understand the risk inherent in peer-to-peer lending agreements.

The peer-to-peer lending platforms’ use of debt securitization means that they offload risk to borrowers and lenders. In other words, such platforms do not have “skin in the game” if a loan does not perform. Additionally, because the lending platforms contract with borrowers, investors cannot directly oversee or monitor the process that underwrites their investment, meaning that investors are essentially taking the lending platform’s word for what constitutes different categories of risk. One way of addressing these issues is to apply credit risk retention requirements similar to those required of asset-backed securities by Section 941 of Dodd-Frank. Ultimately, any strategy should link the risk undertaken by the investor to a peer-to-peer lending platform.

Peer-to-peer lending has potential to match investors with variable risk-tolerances with borrowers that may be otherwise unable to obtain a loan, but it should ultimately provide any efficiency gains via its network effect and lean operations instead of avoiding the risk retention regulations for similar asset-backed securities. Likewise, its underwriting process needs to be transparent to ensure that investors and borrowers are capable of making informed decisions.

Credit insurance and excessive refinancing—older borrowers are often the target of aggressive sales pitches for lump-sum credit and noncredit insurance products: life, accident, disability, unemployment, and property insurance. These products are often packaged into a loan without the borrower’s knowledge or consent, and lenders may fail to inform borrowers that credit insurance is optional. Lenders frequently receive commissions on the sale of lump-sum insurance products, which may be added to the loan amount and generate additional interest income for the lender. Dodd-Frank prohibits including a lump-sum premium in the loan amount if the loan is secured by the borrower’s principal residence.

Solicitation for frequent refinancing of existing debt is a practice that has been aimed at consumers with low incomes. Frequent refinancing results in higher costs than if the consumer had initially received a longer-term loan or obtained a separate loan for additional funds. For example, a 2014 CFPB study found that four out of five payday loans are rolled over or renewed within 14 days. Further, the majority of payday loans are made to borrowers who renew their loans so many times that they end up paying more in fees than the amount of money they originally borrowed. Roughly half of all loans are made to borrowers in the course of loan sequences lasting ten or more loans in a row. The study also looked at payday borrowers who are paid on a monthly basis and found one out of five remained in debt for the entire year of the study. Payday borrowers who fall into this category include many older Americans or disability recipients receiving Supplemental Security Income and Social Security Disability.

The Defense Authorization Act of 2007 includes a provision capping the interest rate on payday loans to military personnel at 36 percent (the same cap many states impose in their usury laws), which effectively means that active military personnel and their families cannot receive payday or car-title loans. Support for the law was based on a Department of Defense finding that payday loans were hurting military preparedness.

Debt collection—debt collection lawsuits have increased across the country, corresponding to rapidly rising debt loads, high credit card fees, and the economic downturn.

Although not all debt collection practices are abusive, complaints about abusive debt collection practices to state attorneys general, the Federal Trade Commission (FTC), and the CFPB have exceeded those for other industries for more than 15 years. According to a recent CFPB study, about one-in-three consumers has been contacted by a creditor or collector attempting to collect a debt within the past year. Consumers who had been contacted reported attempts to collect payment on between two and four debts, and one-third of those who had been contacted reported an attempt to collect in the wrong amount. The increase in collection activities and complaints corresponds to the advent and exponential growth of the debt-buying industry, which purchases large portfolios of defaulted debt for pennies on the dollar. Debt buyers generally receive little or no supporting documentation to prove a debt is owed and thus can attempt to collect on questionable, stale, or discharged debt. Over 30 million Americans are subject to the collection process, whether they actually owe a debt or not.

Debt buyers employ practices and procedures that can lead to abusive debt collection. These include filing false and fraudulent affidavits in court, knowingly suing the wrong consumer (or for the wrong amount), filing lawsuits despite expiration of the statute of limitations, and selling or reselling disputed or discharged debt. Debt buyers also pursue debts that were discharged in bankruptcy, that resulted from identity theft, or that belonged to a decedent.

Unfortunately, most alleged debtors do not appear in court to defend themselves. This may be because they were not properly served, do not understand their legal rights, are in ill health, do not have transportation, cannot skip work, or fear going to court because they do not understand the process. The vast majority of debt collection actions end in default judgments entered by the court, without any evidence the alleged debtor owes the debt or that the amount claimed is valid. Typically, a debt buyer does not even have access to the information needed to support a claim in litigation, including the contract obligating the debtor to pay, documents showing ownership of the debt, or an itemization of the amounts claimed.

The CFPB is considering proposals to overhaul the debt collection market. These reforms would include requiring collectors to scrub their files and substantiate the debt before contacting consumers, limiting collectors to six communication attempts per week (through any point of contact), requiring collectors to include more specific information about the debt in initial collection notices, and requiring collectors to stop collections until the necessary documentation is checked when a consumer disputes the validity of the debt. The CFPB is also considering instituting a 30-day waiting period after a consumer has died during which collectors are prohibited from communicating with parties, including surviving spouses.

Consumer Credit Protection: Policy

Strengthening existing protections

In this policy: FederalLocalState

The Consumer Financial Protection Bureau (CFPB) should place a priority on issuing regulations to eliminate unfair, deceptive, or abusive practices in the alternative financial services industry.

States should strengthen the minimal federal protections established in the Fair Credit Billing Act (FCBA), the Fair Debt Collection Practices Act (FDCPA), and the Fair Credit Reporting Act (FCRA).

The protections of the FDCPA should be extended to creditors’ in-house collection activities.

State and local governments should not engage in unfair debt collection practices, including posting information about alleged debtors online through social media.

Court procedures should be updated to prohibit the entry of judgments in debt collection cases without clear, admissible evidence of the debt, including proof of assignment and an itemization of fees and interest.

Sellers of debt portfolios should not be allowed to sell the debt or the right to collect the debt without documentation that the alleged debtor in question does, in fact, owe the debt.

Debt collectors should be required to provide actual notice to alleged debtors:

  • if a debt is not legally collectible through court process; and
  • that the nominal payment on a debt will revive a debt, making it legally collectible in court again.

The CFPB and the states should adopt legislation or strengthen existing laws to license lenders; ensure compliance with federal and state consumer disclosure laws, and with state small-loan interest rate caps or usury laws; eliminate or strictly limit loan rollovers; require lenders to disclose that the criminal justice system cannot be used for collections; provide consumers with a private right of action; and eliminate unfair, abusive, or deceptive practices.

Banks should not be permitted to set off bank fees from exempt federal benefits.

Congress and the states should pass legislation or strengthen existing laws to curb predatory practices of pension advance lenders and pension investment promoters. Regulators should adopt and enforce regulations to the extent that pension advances and pension investments are covered under existing law.

Interest rates

In this policy: FederalState

The federal government should either prohibit national banks and their subsidiaries from making payday loans or limit loan rates, and it should require banks and their subsidiaries and lending partners to comply with the laws of the state where the consumer receives the loan’s proceeds.

In the case of refund-anticipation loans, the federal government and the states (to the extent applicable) should regulate tax preparers and their financial partners in regard to interest charged.

Congress and the states should establish for all lenders reasonable interest rate ceilings that either correspond to prevailing Treasury bill rates or are based on the amount of funds borrowed and the need to maintain the availability of credit for disadvantaged customers.

Loan prerequisites

In this policy: FederalLocalState

Federal legislation should ensure access to credit on fair and reasonable terms. Oppressive conditions or prerequisites, such as excessive collateral requirements or tie-in financial relationships with lending institutions, should be banned.

Peer-to-peer lending

In this policy: FederalState

Peer-to-peer lending platforms should:

  • evaluate whether borrowers have the ability to repay their loans;
  • be transparent about their underwriting techniques so that investors understand how much risk they are actually taking on; and
  • be required to comply with the laws in their home state, regardless of whether they partner with entities in other states.

Policymakers should require similar credit risk retention standards for peer-to-peer lending platforms as they do for asset-backed security sponsors.

Age and gender discrimination

In this policy: Federal

The CFPB should give priority to enforcing the Equal Credit Opportunity Act and investigate existing credit practices and the availability of commercial credit for older women.

The CFPB should prohibit indirect discrimination against older people by removing distinctions between retirement and employment incomes.

Rule of 78s

In this policy: FederalState

Policymakers should prohibit the use of the rule of 78s in calculating refunds of interest and insurance charges when a loan is repaid early.

Credit reporting

In this policy: Federal

The CFPB should strongly enforce both the FCRA and FCBA. Practices of credit-reporting agencies must be reformed to protect consumers against erroneous information, provide greater consumer access to credit files, enable consumers to correct erroneous information more easily, and require that credit reports be more user-friendly.

Creditors should be required to report credit information to agencies to provide a more complete and accurate measure of consumers’ credit history.

Credit insurance

In this policy: FederalState

Lenders should be prohibited from selling credit and noncredit insurance products and insurance substitutes that are paid for with a lump sum out of the loan’s proceeds. The CFPB should extend the Dodd-Frank Wall Street Reform and Consumer Protection Act prohibition on lump-sum insurance financing in mortgage loans to all types of consumer loans.

States should require lenders to inform borrowers, both orally and in writing, that the purchase of credit insurance is strictly optional.

States should prohibit lenders from receiving commissions on the sale of credit insurance or from selling credit insurance to their borrowers through an affiliate or a subsidiary insurer.

Refinancing

In this policy: State

States should place limits on the refinancing of consumer loans by requiring lenders to disclose the cost of refinancing compared with the cost of obtaining a separate loan and by restricting the number of times and the frequency with which loans can be refinanced.