Here's the real reason payday, title loans are such a massive problem

New research from the Consumer Financial Protection Bureau shows just how easy it is for cash-strapped borrowers to get sucked 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 fueled by triple-digit interest rates (except in states where they are either banned or have specific interest rate caps) and are issued without taking into account the borrower’s ability to repay the loan. While payday lenders use a borrower’s proof of income (like a pay stub) to underwrite their loan, auto title lenders use a borrower’s car as collateral.

Because the value of the title loan is based on the car’s value, title loans also tend to be much larger than the typical payday loan — $959 vs. $392. On average, a title loan consumes half of the average borrower’s paycheck, according to past research by Pew Charitable Trusts. If the loan isn’t repaid, the lender has the right to take ownership of the car.  

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“The typical borrower can only afford [to pay back a loan that is] about 5% of their paycheck to make ends meet,” says Nick Bourke, head of Pew’s small dollar loans project.

The CFPB’s data shows that one-third of title loan borrowers default on their original loan and one in five borrowers has had their cars repossessed. Most title loans have to be repaid within 30 days.

Some 80% of title loan borrowers take out another title loan once they pay off their original balance. Thirty days later, nearly 90% re-borrow those loans again. All in all, more than half of all title loans the CFPB tracked resulted in at least three additional loans and one-third of all loans initiated resulted in seven or more loans. 

So, how do you solve a problem like title loans? The CFPB’s answer, so far, has been to propose new rules that would force these lenders to beef up their underwriting practices. The agency was expected to issue those new rules in early 2016 but has yet to do so. In the meantime, it’s also putting pressure on big banks and credit unions to help fill the void that will be left once payday and title lenders are elbowed out of the market by stricter regulations. The idea is that traditional banks could offer small dollar loans at a relatively low interest rate to consumers in dire financial straits, giving them a much-needed alternative.

The real issue here isn't that title loans and payday loans exist. It's that the industry has yet to come up with a better alternative for consumers in a financial pinch.

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 the CFPB’s new rules on small dollar loans are released. “If the CFPB sets standards you will see a lot more banks getting into this market and making 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 could see banks making small cash loans to existing checking account customers.”

As it stands, only 1 in 7 federal credit unions offers a payday alternative loan, according to the Pew Charitable Trusts. Their business is a drop in the bucket — 170,000 such loans were issued by credit unions in 2014, compared with more than 100 million payday loans overall.

Plus, banks already have their own version of a small dollar loan – the overdraft fee, which just so happens to be a multibillion-dollar source of revenue. They don’t look or feel like a payday loan but they have a similar effect. The majority of the time, the transactions that led to bank overdrafts are $24 or less and are repaid within 3 days, according to past research by the CFPB. But the average bank will still charge that customer a $34 overdraft fee. 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 bills or make their rent payment on time, Pew’s research has shown. On a call with reporters Tuesday, the CFPB declined to offer tips on where customers can go for alternative sources of emergency loans. Problem is, there aren’t many.

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

Making small-dollar loans safer — but not impossible — to procure seems like the answer here. It’s a delicate balancing act for regulators. Rules for lenders have to be tight enough so small-dollar lenders aren’t able to take advantage of the financially vulnerable but not so tight that they put the entire industry out of business.

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

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