You might think that policymakers would have moved long ago to protect consumers from lenders who charge a whopping 400 percent average annual percentage rate for their products.

But the decades-old payday loan business is only now facing its first federal regulations. Last Thursday, the Consumer Financial Protection Bureau got the ball rolling with its long-awaited proposed rules for small-dollar lending.

"This is a huge step in the right direction," says Suzanne Martindale, staff attorney at Consumers Union, the policy and advocacy arm of Consumer Reports. The proposed rule sets critical standards for payday loans, car title loans, and similar types of credit that promise fast cash—for a steep price—in the 30 states that don’t already prohibit or significantly limit the practice.

The 1,500-page rule would require lenders to make sure borrowers can afford the payments on high-rate payday loans, and it would prohibit them from repeatedly overdrawing a borrower’s checking account to extract payments. It would also permit less underwriting scrutiny if the loan meets certain standards, such as a 28 or 36 percent APR cap.

But while the proposal is a major first step and could clean up the worst abuses in the high-cost lending market, there are some exemptions to the rule that concern Martindale and other consumer advocates.

Mixed Reviews

For example, a key provision of the proposal requires lenders to determine if the borrower can afford to repay the full amount of the loan payments due, without having to re-borrow within 30 days. Research by the CFPB found that 80 percent of payday loans due in a single payment were refinanced with the same kind of high-price loan, often again and again.

But Tom Feltner, director of financial services at the Consumer Federation of America, sees a loophole that lenders could exploit to maintain business as usual. "There is an exemption that allows lenders to make up to six loans per year without determining ability to repay—if the loan is for $500 or less. We think one unaffordable loan is too many," says Feltner.

The Pew Charitable Trusts, which have done extensive research on small dollar loans, says the CFPB rule will help consumers somewhat by shifting the business to installment loans, with payments spread out over several months, up to two years. Installment loans are much more affordable and manageable than traditional payday loans, which must be repaid in full on the next payday, typically only one to two weeks after borrowing the money.

But Pew has serious misgivings, because the proposed rule doesn’t provide “product safety standards.” Those, for example, would limit the installment payments to 5 percent of the borrower’s paycheck. That threshold, Pew studies have shown, significantly improves the likelihood of successful repayment and reduced default.

Alex Horowitz, senior officer with Pew's small-dollar loans project, slammed the CFPB proposal. "Borrowers are looking for three things from payday loan reform: Lower prices, small installment payments, and quick loan approval. The CFPB proposal went zero for three," says Horowitz. 

Under the proposed rule, Horowitz says a payday installment loan of $400, repaid over three months, will still cost a borrower $350 to $400 in fees. Pew says banks could make that same loan for $50 to $60 if the CFPB limited repayments to five percent of the borrower's income and didn't require onerous underwriting paperwork. 

Sam Gilford, a CFPB spokesman, says the rule is only a proposal at this stage, and "we're asking the public for comment." It may take one to two years for the CFPB to review public comments, issue a revised proposal or final rule, and set an effective date for implementation.

A payday loans industry representative did not respond to our request for comment.

What You Can Do

You may think you'd never agree to payday loan terms in a million years. But a just-released Federal Reserve study found that almost half of us could not cover an emergency expense costing as little as $400.

None of us is immune to a sudden reversal of fortune. Health problems, job loss, divorce, or other hardships can easily put the best household money managers in a precarious position at any time. Then, an unexpected car repair or high health insurance deductible might be all it takes to break the budget and create a need for the kind of fast cash payday loans promise.

Until strong consumer protections are firmly in place, if you need fast cash, try these better options instead of a payday, car title, or other small-dollar loan:

  • Consider a "Payday Alternative Loan" offered by some credit unions. PALs come with low fees and interest rates. Houston Federal Credit Union, for example, writes one- to six-month PALs of $200 to $1,000 with no credit check and an APR of 28 percent—or 23 percent with payments made via automatic payroll deduction. The CFPB rule exempts loans that meet PAL standards set by the National Credit Union Administration.
  • See if you can qualify for a traditional installment loan from a local community bank. These smaller institutions are known for good customer service and a community-minded spirit in finding ways to serve local residents.
  • Swallow your pride and borrow from friends or family.
  • Try to negotiate a time payment arrangement with the repair shop, health care provider, or creditor whom you have to pay.