The Dangers of Online Lending

New rules are necessary to keep up with the changing face of online lending.

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A man walks into a payday lending business Wednesday, Feb. 1, 2006, in Tacoma, Wash. Last year the Legislature enacted law that banned payday lenders from contacting the boss of a military borrower to collect an overdue payment. This year, under Senate bills sponsored by Sen. Darlene Fairley, D-Lake Forest Park, the military is seeking to cap annual interest at 36 percent, limit borrowers to one $500 obligation at a time, and prohibit a lender from giving loans to a borrower's spouse.

Payday lenders have long dotted the landscape of lower-income communities across the country. Their loans, which offer short-term credit at exorbitant interest with little consideration of a borrower's ability to repay, are often accompanied by difficult repayment terms and aggressive collection practices.

For years, policymakers and consumer advocates have worked to prevent borrowers from getting trapped in a long-term cycle of debt. But a recent development, online payday lending, raises new policy challenges and poses a particular threat to consumer protection efforts at the state level.

Fourteen states and the District of Columbia have effectively banned payday lending. Other states have taken steps to counter the worst abuses by, for example, limiting the number of back-to-back loans. Meanwhile, a growing number of lenders have set up shop on the Internet; and many now assert the right to market their products wherever they please, ignoring state consumer protections entirely.

As policymakers and consumer advocates continue their efforts to cap interest rates and counter the worst abuses, it is crucially important to stop the online players from circumventing state laws, and to make sure that banks cannot facilitate their efforts to do so.

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Applying for a payday loan is simple – dangerously so. The borrower provides his or her name, social security number, employment history, monthly income and other basic information. The lender also obtains the borrower's bank account and routing numbers. The loan proceeds are then deposited into that account, and the payments are withdrawn on or around the borrower's payday.

Whether we're talking about a storefront or an online loan, the lender relies on direct access to a bank account to collect payments. Unlike storefront payday loans, though, online loans are usually repaid in installments; and instead of leaving a post-dated check on file with the lender, borrowers authorize lenders to make electronic withdrawals directly from their bank accounts.

This authorization can result in serious problems later in the life of the loan. When borrowers agree to let a lender directly debit payments from their checking account, the permission is often difficult to revoke. Consumers have complained about being harassed at work. Lenders often make repeated attempts to debit the same payment, triggering multiple overdraft fees, which can make a borrower's already tenuous financial condition worse. Unlike credit cards or car loans where a borrower has some control over when to pay the bill, these payments are automatically withdrawn. Borrowers can be left with no money to pay their mortgage or rent bills, or to buy groceries or other necessities.

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In the event of default, some loan contracts even allow lenders to collect the entire amount owed, often through the little-known practice of remotely created checks. Remotely created checks, unlike the paper checks used to secure storefront payday loans, are generated by the lenders themselves and not signed by the borrower.

These payments are largely unmonitored, and lack the strong fraud prevention mechanisms necessary to protect consumers from telemarketing scams and other ripoffs. In part because of these fraud prevention limitations, remotely created checks have been widely replaced by better regulated forms of electronic payment, and some advocates have called for a ban on their use in consumer transactions.

Problems with payment and collection tactics aside, more and more payday lenders are violating state consumer protection laws outright. Currently, at least 16 tribes and numerous offshore lenders have launched online operations. These tribal and offshore lenders routinely market and originate loans all over the country, including the states in which payday lending is effectively prohibited. In states that permit payday lending, they claim to be exempt from basic licensing and consumer protection requirements. Even in situations where loan companies are owned and operated by tribes, these lenders are still required to follow state as well as federal laws when making loans.

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As long as these consumer protection challenges go unaddressed, borrowers with online payday loans will continue to face abusive practices and limited options for redress if they run into trouble. Ensuring that all lenders play by the same set of rules and that consumers can make informed choices about their credit options means both addressing payment and collection abuses and cracking down on lenders who seek to evade much-needed and hard-fought state consumer protection laws.

Federal banking and consumer protection agencies play an important role in protecting consumers from abusive or illegal online payday lending and have begun to take notice. Recently, the Consumer Financial Protection Bureau announced that it had begun researching the online lending industry. The bureau has also initiated a separate inquiry into practices at a number of online lenders claiming tribal sovereign immunity from state laws.

Other regulators have stepped in as well. Last month, the Federal Deposit Insurance Corporation issued a letter advising the banks it supervises that processing payments for online payday lenders and other high-risk merchants could expose them to legal and reputational risk. While heightened scrutiny of the enabling role of banks is consistent with longstanding supervisory expectations from federal banking regulators, this announcement comes at an important time. State regulators in California, New York, Maryland and other states have recently turned their attention not only to lenders who are violating state consumer protection laws, but also to the banks that make unlawful loans possible. The Department of Justice, the Federal Trade Commission, and the Office of the Comptroller of the Currency have also taken steps to prevent online payday lending abuses.

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There is still more to be done. The online lending market is changing rapidly, and new consumer protection tools are necessary to keep consumers safe. Allowing the continuation of abusive practices or the outright evasion of current law will lead to the erosion of over a decade of successful state efforts to protect consumers from the problems associated with high-cost lending. To eliminate the worst abuses in online lending, we need strong regulations both for the lenders and for the banks that abet them. And Washington needs to play a role.

Last spring, Democratic Sen. Jeff Merkley of Oregon introduced the Stopping Abuse and Fraud in Electronic Lending Act of 2013. Merkley's proposal, and a similar House bill sponsored by Oregon Democratic Rep. Suzanne Bonamici, would require all lenders, both online and storefront, to comply with state consumer protections. It would also restrict the use of remotely created checks and prohibit the use of so-called lead generators – brokers who collect employment and bank account information from consumers and sell it to the online lenders. These protections, and continued vigilance on the part of banking and consumer protection agencies, are critical to ensuring that consumers are protected regardless of whether they take out a payday loan at a storefront or online.

Tom Feltner is director of financial services at Consumer Federation of America, a member of Americans for Financial Reform.

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