Here’s the real reason why payday loans are such a huge problem

A new study from the Consumer Financial Protection Bureau shows how easy it is for cash-strapped borrowers to get drawn into a vehicle title loan debt trap.

Auto title loans share many of the same nefarious qualities that have made their cousin, the payday loan, such a hot target for regulators. Both products are powered by three-digit interest rates (except in states where they are prohibited or have specific interest rate caps) and are issued without regard to the borrower’s ability to repay the ready. While payday lenders use a borrower’s proof of income (like a pay stub) to secure their loan, auto title lenders use a borrower’s car as collateral.

Since the value of the title loan is based on the value of the car, title loans also tend to be much larger than the typical payday loan – $959 vs. $392. On average, a title loan consumes half the average borrower’s salary, according to previous research from Pew Charitable Trusts. If the loan is not repaid, the lender has the right to become the owner of the car.

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“The typical borrower cannot afford [to pay back a loan that is] about 5% of their paycheck to make ends meet,” says Nick Bourke, Pew’s Small Dollar Loans Project Manager.

CFPB data shows that a third of title deed borrowers default on their original loan and one in five borrowers have had their car repossessed. Most title loans must be repaid within 30 days.

About 80% of home loan borrowers take out another home loan once they have paid off their original balance. Thirty days later, almost 90% are borrowing these loans again. Overall, more than half of all securities loans tracked by the CFPB resulted in at least three additional loans and a third of all loans initiated resulted in seven or more loans.

So how do you solve a problem like securities lending? The CFPB’s response, so far, has been to propose new rules that would require these lenders to tighten their underwriting practices. The agency was supposed to publish these new rules in early 2016, but has yet to do so. Meanwhile, it also puts pressure on big banks and credit unions to help fill the void that will remain once payday lenders and title lenders are squeezed out of the market by tougher regulations. The idea is that traditional banks could offer small dollar loans at a relatively low interest rate to consumers in financial difficulty, providing them with a much-needed alternative.

The real problem here is not that title loans and payday loans exist. It’s that the industry has yet to find a better alternative for consumers in financial difficulty.

There are reports that at least three major banks are testing a payday loan alternative, but for the most part banks are biding their time until new CFPB rules on small dollar loans are released. “If the CFPB sets standards, you’ll see a lot more banks come into this market and make loans that cost 6 times less than what payday and title loans cost,” Bourke says. “I don’t think you’re going to see banks offering auto title loans, but you might see banks giving small cash loans to existing checking account customers.”

Currently, only 1 in 7 federal credit unions offer an alternative payday loan, according to the Pew Charitable Trusts. Their business is a drop in the ocean – 170,000 such loans have been issued by credit unions in 2014, compared to more than 100 million total payday loans.

Plus, banks already have their own version of a small dollar loan – overdraft fees, which happen to be a multi-billion dollar revenue stream. They don’t look or sound like a payday loan, but they have a similar effect. The majority of the time, transactions that resulted in bank overdrafts are $24 or less and are refunded within 3 days, depending on previous research by the CFPB. But the average bank will still charge that customer an overdraft fee of $34. That’s effectively a 140% interest charge on a three day loan.

Most people who turn to payday loans or title loans are simply trying to make ends meet, looking to pay their bills or pay their rent on time, according to Pew research. In a call with reporters on Tuesday, the CFPB declined to offer advice on where customers can go for alternative sources of emergency loans. The problem is, There are not a lot.

With wages stagnating and fixed costs rising, American households feel pressured by day-to-day expenses, let alone able to cover unexpected expenses. Sixty-three percent of people said they wouldn’t have the money to cover a $500 car repair or a $1,000 medical bill, according to a recent Bankrate survey.

Making small-dollar loans safer — but not impossible — to obtain seems to be the answer here. This is a delicate balancing act for regulators. The rules for lenders must be strict enough that small lenders cannot take advantage of financially vulnerable people, but not so tight as to bankrupt the whole industry.

Woodruff Mandi is a reporter for Yahoo Finance and host of Brown Ambitiona weekly podcast about career, life and money.

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