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As of 10/19/22, the United States Court of Appeals for the Fifth Circuit has ruled that the Consumer Financial Protection Bureau is in violation of the constitution and invalidated the Small-Dollar Rule, though this decision is likely to be appealed.
The CFPB's new Small-Dollar Rule largely applies to (you guessed it) small-dollar loans. Although individual states may define small-dollar loans differently, the CFPB set a definition in the regulation itself, (see §1041.3) which explains precisely which loans are covered by the rule and need to follow it's requirements on payments, customer communication, and recordkeeping.
What Loans are Subject to the Rule?
The first type of loan the rule covers are short-term loans. While other federal or state regulations might draw the line differently, the rule says that it's any closed-end credit where the borrower has to pay back "substantially the entire amount of the loan within 45 days," (§1041.3(b)(1)).
The regulation is somewhat vague as to what "substantially the entire amount" means — the official interpretation notes that whatever substantial means "depends on the specific facts and circumstances of each loan".
Longer-Term Balloon-Payment Loans
Even if a loan has a term longer than 45 days, it can still be subject to the rule if the loan schedule includes a "balloon payment". A balloon payment is either a single payment for the entire loan amount, or any payment that's twice as large as any other (§1041.3(b)(2)).
This might include a loan where the borrower has the option to make only minimum payments until a specified date when their remaining balance all comes due at once. If that final payment would be more than twice the size of the minimum payments, then the loan is subject to the rule (§1041.3(b)(2)(ii)(B)).
High-Cost Longer-Term Loans
For these loans to be subject to the rule, the lender would need to meet the requirements of having both an APR of 36% or higher and a "leveraged payment mechanism". This goes for both closed-end and open-end credit. For open-end credit, this condition is met if the APR reaches 36% during any billing cycle or any time there is a balance of $0 and the lender imposes a finance charge. If an open-end credit meets this condition at any point, it is subject to the rule for the rest of the plan's duration. However, credit cards are an exception, as detailed below.
What is a "leveraged payment mechanism?"
A leveraged payment mechanism is any means of a lender initiating the transfer of money from a borrowers account (§1041.3(3)(c)). For instance, ACH and bank card transactions in LMS are leveraged payment mechanisms because you have the borrower's payment profile saved and can initiate a payment without any input from the borrower. The official interpretation explains that there are multiple ways the lender can withdraw funds from a borrowers account, such as check, electronic fund transfer, created checks/payment orders, and the transfer by an account-holding institution.
Loans that are not covered by the Small-Dollar Lending Rule initially can become a covered loan at any time during the loan's term if it meets the criteria at a later point due to extensions or increased cost of credit.
What Loans are Not Subject to the Rule?
If a loan doesn't match any of the three criteria above, it's not covered by the rule and you don't need to worry about any of the regulations, end of story. But for loans that appear to match, there are also some exceptions for certain types of loans. Even if the loan meets the above criteria, the following types of loans are exempt.
Certain Purchase Money Security Interest Loans
"Certain purchase money security interest loans" are exempt from the rule (§1041.3(d)(1)). These are loans where a lender extends credit to a borrower for the sole purpose of purchasing a good, which is then used as collateral. If the borrower fails to pay back the loan, the lender repossesses the collateral item. Basically, the CFPB trusts that if you have the option to repossess the collateral, you'll do that instead of repeatedly attempting charges, so you're exempt. The official interpretation states that the loan is "made "solely and expressly" for purchasing a good if the loan amount is "approximately equal to, or less than, the cost of acquiring the good." So, an auto loan, or any other loan where buying the collateral item is the main purpose of giving credit, is exempt from the rule. But a loan for $1,000 with a $300 collateral item would still be subject to the rule.
Real Estate Secured Credit
This rule does not apply to any loan that uses real estate as collateral (§1041.3(d)(2)). If the lender records or perfects the property with a lien in the loan contract, the loan is exempt from the rule. The law states in the interpretation that "if the lender does not record or perfect the security interest during the term of the loan, the credit is not excluded" and the loan would still be subject to the rule. It also clarifies that any personal properties that are used as a dwelling, like a mobile home, fall under the same category and are likewise exempt.
Non-Recourse Pawn Loans
The rule makes an exemption for pawn loans where the lender has physical possession of the pawned item for the entire length of the loan. (§1041.3(d)(5)). The interpretation makes it clear that these loans are only exempt if selling the pawned item is really their only recourse when borrowers fail to repay: If any borrower or co-signor "is personally liable" for a difference between the remaining loan balance and the value from the pawned item, then the loan is still subject to the rule.
Overdraft Service and Lines of Credit
An account-holding institution like a bank or their partner might extend an overdraft line of credit to their consumers. If their account lacks funds for a transaction, the bank would use the overdraft credit rather than charging an overdraft fee (which would help consumers avoid late fees from whoever initiated the charge). Overdraft services and overdraft lines of credit are exempt from the rule (§1041.3(d)(6)). The official interpretation points lenders toward 12 CFR 1005.17(a), where they can find a more thorough definition for these programs.
Wage Advance Programs
A wage advance program, as explained in Fair Labor Standards Act, is where an employee requests payment from their employer before the end of a pay period. Wage advance programs are exempt from the small-dollar rule if they meet two requirements:
- To be exempt, the amount the employee borrows must be less than their accrued wages in the current pay period. If the employee has already worked 10 days from a 14 day pay period, they'd be borrowing less than they've already earned, and the wage advance program is exempt from the rule. But if an employee has only worked for 2 days in the pay period and is requesting a full two weeks' wages in advance, then this advance is enough like a payday loan that it's subject to the rule. Depending on the point of the pay period the employee is in, a wage advance program may or may not be subject to the rule.
- To be exempt, the employer must promise in the loan agreement that there will be no extra fees, except for an initial participation fee; that if the employee can't repay the advance, then the employer has no recourse against the borrower; and that the employer will not engage in debt collection activities, such as selling to a third party or reporting to a credit agency.
No-Cost Advances are loans where the lender agrees in the loan contract that if the borrower does not repay, the lender has no claim against them (§1041.3(d)(8)). The lender will not be involved in any debt collection activities such as selling to a third party or reporting to a credit agency. These loans are exempt, which is funny, because the lender by definition wouldn't be involved in any of the regulated activities like repeatedly charging an account.
Alternative loans are similar to a payday loan, but are extended by a Federal Credit Union and meet certain conditions relating to the loan terms and underwriting. This is all laid out in another set of regulations, 12 CFR 701.21(c)(7)(iii). The definition for alternative loan is very involved, but any loan that qualified under §701.21 has safe harbor here and is exempt from the rule (§1041.3(e)).
Conditional Requirements for Alternative Loans
Loan Term Conditions
- The loan is not open-ended.
- The loan has a term that is no less than 1 month and no more than 6 months.
- The principal of the loan is no less than $200 and no more than $1,000.
- If the loan is repayable in two or more payments and if all the payments are 'substantially' equal in amount (equal intervals) and the loan amortizes during the term of the loan.
- In determining whether or not a loan has substantial payments, the loan is substantial if the amount of each scheduled payment is equal to or within a small variation of the others. The lender may disregard collecting payments in whole cents.
- When determining whether a loan has substantially equal intervals, the loan payments are substantially equal if the payment schedule requires repayment on the same date each month (or in the same number of days prior to a scheduled payment).
- The lender doesn't impose any charges other than the rate and applications that are permissible under regulations issued by the NCUA at 12 CFR 701.21(c)(7)(iii). The cost of an application fee must not exceed 20$.
Borrowing History Condition
Prior to making an alternative loan, the lender must determine from the customers history that the loan will not result in the customer being in debt on more than three outstanding loans (within a period of 180 days). The 180-day period begins 180 days prior to the origination of the loan and ends on the origination date of that loan.
Income Documentation Condition
The lenders must maintain policies and procedures for documenting proof of the customers recurring income and comply with those policies. Lenders can use a procedure for documenting the recurring income that satisfies the lender's own underwriting obligations; lenders may choose to use the procedure contained in the National Credit Union Administration at 12 CFR 701.21(c)(7)(iii) . The interpretation states that the NCUA, "recommends that federal credit unions document consumer income by obtaining two recent paycheck stubs.
Loans that are made by the Federal credit union in compliance with the NCUA at 12 CFR 701.21(c)(7)(iii). These loans are those that fall under the loan term conditions, borrowing history, and income documentation.
Accommodation loans would normally be subject to the rule, but the CFPB has extended you a bit of leniency if you have relatively few of them (§1041.3(3)(f)). At the time of the loan being created, these loans are exempt if they meet both of these conditions:
- The lender collectively has made 2,500 or fewer covered loans in the current calendar year and 2,500 or fewer such covered loans in the preceding calendar year.
- In the most recent tax year if the lender derived no more than 10 percent of their total income from covered loans. If the lender was not in business in the prior tax year, the lender "reasonably anticipates" that they will derive no more than 10 percent of their total income from covered loans during the current tax year. The official interpretation makes it clear that "reasonable" anticipation involves both looking at income to date and accounting for any upcoming changes to their business plans.
Now that you're clear on which loans are subject to the rule and which are exempt, you'll probably want to dive into our article on it's exact requirements.