What’s the biggest problem with payday loans?

The obvious answer would seem to be “high interest rates.” But interest rates are often tied to credit risk, and so charging high interest rates is not always wrong. Another answer may be that the loans appear to be targeted toward minorities. But research shows that the industry appeals to those with financial problems regardless of race or ethnicity.

No, the problem with payday loans —what makes them a debt trap — is “rollovers.”

A study by the Consumer Financial Protection Bureau (CFPB), the U.S. government’s consumer protection agency, found that four out of five payday loans are rolled over or renewed within 14 days. 40 percent of borrowers take out only one loan, about 15 percent take out two loans in sequence, and 45 percent take out three or more. But 14 percent of borrowers take out more than 11 loans in a row.

The CFPB is considering proposing rules that would end payday debt traps by requiring lenders to take steps to make sure consumers can repay their loans.

All lenders making covered short-term loans would be required to adhere to one of two sets of requirements. The first set would “prevention requirements” which the CFPB says:

[W]ould eliminate debt traps by requiring lenders to determine at the outset that the consumer can repay the loan when due – including interest, principal, and fees for add-on products – without defaulting or re-borrowing. For each loan, lenders would have to verify the consumer’s e, major financial obligations, and borrowing history to determine whether there is enough money left to repay the loan after covering other major financial obligations and living expenses.

Under this set, the requirements include:

• Lenders would generally have to adhere to a 60-day cooling off period between loans.

• The consumer could not have any other outstanding covered loans with any lender.

• To make a second or third loan within the two-month window, lenders would have to document that the borrower’s financial circumstances have improved enough to repay a new loan without re-borrowing. They would have to verify, for example, that the consumer’s e had increased following the prior loan.

• After three loans in a row, all lenders would be prohibited from making a new short-term loan to the borrower for 60 days.

The second set would be “protection requirements,” aimed at protecting against debt traps by “limiting the number of loans that a borrower can take out in a row and requiring lenders to provide affordable repayment options.”

These protections would include the following restrictions:

• The loan could not exceed $500, last longer than 45 days, carry more than one finance charge, or require the consumer’s vehicle as collateral.

• The consumer could not have any other outstanding covered loans with any lender.

• Rollovers would be capped at two – three loans total – followed by a mandatory 60-day cooling-off period.

• The second and third consecutive loans would be permitted only if the lender offers an affordable way out of debt. The Bureau is considering two options for this. The first would require that the principal decrease over the three-loan sequence so that it is repaid in full when the third loan is due. The second would require the lender to provide a no-cost “off-ramp” if the borrower is unable to repay after the third loan, to allow the consumer to pay the loan off over time without further fees.

• The consumer could not be more than 90 days in debt on covered short-term loans in a 12-month period.

I’ve previously written about my own experience with payday lending and getting caught in a debt trap. In hindsight, would I have still used a payday loan? Absolutely. I did it because I was desperate. And the payday pany was more than willing to take advantage of my desperation. But the alternative was even more dire.

What would I have done if the payday lending option didn’t exist? I don’t know. But if these CFPB regulations are put in place, consumers who find themselves in similar financial straits may soon find out.

“This is rulemaking that could remove an entire product,” says David Newville, director of government affairs at the Corporation for Enterprise Development. “I think most reasonable people who are outside of the core industry recognize that the payday loan, the traditional payday loan, is not a good product. But at the same time, they have reservations: If this goes away, what will happen if there is nothing to fill the void? Will borrowers turn to loan sharks?

This is also my primary concern about these proposed regulations. I hate “predatory”lending and would love to see the underlying business model of most such lending services disappear. But until we have a better model to offer people with short-term financial problems, payday lending may be the best solution for people who have no other options.

Destroying the system with regulations won’t solve the financial problems of those in need. So what will be the effect? Will it prevent rational but desperate people from making systematic mistakes that lower their own financial well-being? Or will it merely push them to seek even worse alternatives. Before we try to “fix” the problem we need to know more about what the solution will cost the poor.