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Payday lending and CUs

Credit unions struggling for loan growth or fee income shouldn't overlook the possibility of extending payday loans. Payday lending isn't necessarily serving the underserved, as these members historically have just gone down the street for this need. However, payday lending is certainly serving members of limited means. Most members have no need for payday loans, but those who need short-term financing may look to the credit union to meet that need.

A variety of programs may fall into payday lending, including cash-advance loans, postdated check loans, deferred deposit loans, and deferred check loans. Typically in payday loan transactions, a cash advance is made in exchange for the consumer's personal check or authorization to debit the consumer's account in the near future. Both lender and borrower understand there are no funds currently on deposit to cover the advance, but funds are expected soon-the next payday. Thus, the lender agrees not to cash or deposit the borrower's check or initiate the debit until the designated future date.

Of course, the consumer pays a fee in connection with the loan advance. Upon maturity (payday), the consumer's check would be cashed or deposited, or a debit would be initiated to repay the obligation. The lender may also allow the consumer to extend the repayment.

It's important to distinguish payday lending from check cashing. Generally, businesses that offer check cashing for a fee aren't considered lenders. While check cashing provides consumers with the same quick access to cash, funds are being exchanged, not loaned.

PAYDAY LENDING REGULATION

A corresponding growth in state regulation has accompanied the recent growth in check-cashing services and payday lending. Most states provide some form of regulation of both check cashers and payday lenders. For credit unions, the regulation of payday lending activities will depend on the characteristics of the payday loan, particularly the pricing.

All credit unions certainly have the authority to make short-term consumer loans. In fact, many would argue that this was the original purpose of credit unions. Credit unions also have broad authority to establish appropriate repayment and security terms. So whether transactions are based on held or postdated checks, deferred deposits, or debits, payday loans should generally fall within credit unions' consumer loan authority. The critical limitation for credit unions is pricing.

Federal credit unions are limited to charging interest rates of no more than 18% per annum on any loan. State-chartered credit unions would need to review their state credit union acts, but even under a federal parity power or most-favored lender doctrine, they may be limited to 18% or less. In a typical payday loan transaction, staying below 18% may not be easy. For example, a payday advance of $400 for a 20-day term typically carries a $50 cash-advance fee-an effective annual percentage rate of 228%.

This puts credit unions at a disadvantage with competitors who can charge a higher price to compensate for the risk of such loans. For credit unions, this dilemma isn't solved by creating different pricing components, such as cash-advance fees or check-cashing charges. Regardless of the label, these charges generally constitute finance charges for usury purposes.

THE CUSO ALTERNATIVE

Credit unions blocked by usury limits may consider forming a credit union service organization (CUSO) to offer payday loans with higher risk-based pricing. Under the CUSO alternative, several issues arise, such as whether payday lending is a permissible CUSO activity, and what state consumer finance licensing and regulations might apply.

For federal credit union CUSOs, the door currently appears closed. National Credit Union Administration Reg 712.5 doesn't include consumer lending within the finite list of activities permissible for CUSOs. State-chartered credit unions, on the other hand, may have broader authority. Many state credit union acts permit CUSOs to engage in the same activities as credit unions, including short-term consumer lending.

While CUSOs may have authority to engage in consumer lending, if the interest rate for payday loans exceeds a state usury limit, the CUSO may need to obtain a consumer finance or small loan company license. Licensing requirements generally involve background investigations of financial responsibility, experience and character fitness, and bonding requirements.

CUSOs must carefully review state law limitations in handling checks. Some states don't permit loans on postdated checks or deferred presentment arrangements. Similarly, payday loan extensions could constitute "loan financing," which many states prohibit. Whatever happened to the simple task of making small loans to people of modest means?

TRUTH IN LENDING

Up until a year ago, there was debate within the financial services industry about whether payday lending was subject to Truth in Lending (Regulation Z) compliance. Some payday lenders argued that state laws don't expressly treat such transactions as credit, and that the Truth in Lending Act couldn't pre-empt state check-cashing laws. The Federal Reserve Board dispelled such notions by amending the Staff Commentary to Reg Z, clarifying that payday loans involve an agreement to defer payment of a debt and constitute "credit" under Reg Z.

The Fed distinguished noncredit transactions, including contemporaneous check-cashing transactions on the routine delay in a debit processing where there's no agreement to defer presentment of the check. It also clarified several important points. First, in some states, the fees charged for payday loans and similar transactions may not be considered interest or finance charges, but under Reg Z, such fees may be finance charges. Second, Truth in Lending doesn't affect a state's authority to regulate or prohibit payday lending activities. Businesses that regularly extend payday loans and meet the definition of "creditor" must provide consumers with Truth in Lending disclosures.

BR WITT is an attorney with Farleigh, Wada, & Witt in Portland, Ore.