Federal Regulators Scrutinize Banks' 'Advance Direct Deposit' Loans


Need cash in a hurry?

People who have run to the neighborhood cash advance outlet for quick money are finding more sources for short-term loans in unexpected places -- local bank branches.

At least five regional and national banks now offer versions of "advance direct deposit" loans. Banks advance borrowers the money, with the loans repaid from scheduled future direct deposits -- usually from paychecks or Social Security and other government benefits.

Consumer groups say the loans closely mimic the terms of controversial high-interest payday loans offered at nonbank, retail outlets in urban and rural areas across the country.

"Advance deposit loans are billed as short-term, but snare consumers in long-term debt," says Kathleen Day, a spokeswoman for the Center for Responsible Lending, a North Carolina consumer advocacy and research organization.  "What do you think the chances are that a person who takes a loan that's big interest and short term can pay back the loan and fee and still have enough for goods and services? Not high," Day says.

In February 2012, the group was one of 250 national and regional consumer, religious and community groups and individuals asking federal regulators "to take immediate action to stop banks from making unaffordable, high-cost payday loans."

Rising demand from some banking customers for small-dollar, short-term loans has led U.S. Bank, Regions, Guaranty and Fifth Third banks to offer "advance deposit" loans ranging from $1 to $1,000. A fifth bank, Wells Fargo, has been offering short-term loans since 1994.

The new federal financial watchdog agency, the Consumer Financial Protection Bureau (CFPB), has launched closer scrutiny of both banks and payday lenders offering high-interest, small-dollar loans with an eye on whether these loans are fairly marketed to low-income consumers.

How the loans work

Here's how advance deposit loans work:

Say you need $100 to pay your rent or cover some other expense, but don't have the money in the bank. You've been receiving $500 monthly via electronic deposit. The bank agrees to a loan on the assumption that it will be able to automatically draw the full amount plus a fee from your next $500 deposit. There's no check of the borrower's credit history. The loans are popular partly because consumers can gain access to money quickly. The fee usually ranges from $7.50 to $10 per $100 borrowed. Guaranty Bank charges a flat $30 each time a customer applies for the loan. Repayment is required within 35 days. (See chart.)

Consumer groups say that people who use these loans are usually the most needy but least able to repay them on time. The bank repays itself regardless of whether borrowers have sufficient deposits in their bank accounts. This can create an overdraft in the account.

Opponents of the loans say that while the fees appear appealingly low, when calculated as interest and compounded annually, the loans are actually much higher than other loan and credit products. The APR equivalent on an advance direct deposit loan may range from 120% for a 35-day repayment term to more than 400% if the period is two weeks or less. Credit cards typically charge 10% to 25%, depending on creditworthiness. Home equity loans are even lower.

Nessa Feddis, vice president and counsel of the American Bankers Association trade group, said in a statement to the Office of the Comptroller of the Currency that its "inappropriate" to measure the cost of advance loans by APR because "they are not annual loans."

Banks: Loans aren't for everyone

Banking industry representatives defend their products as legitimate services addressing a common need -- quick cash -- for a segment of their customer base. They also say the loans are closely monitored to ensure that consumers do not use them unwisely. In addition, all of the banks give warnings to potential customers in their product guides and literature that the loans are expensive and not designed as long-term financial solutions.

U.S. Bank, for example, has this warning in bold type: "Checking Account Advance is designed for unexpected short-term credit needs and is an expensive form of credit. If you decide to borrow, borrow only as much as you can afford to repay from your next deposit."

Richele Messick, a spokeswoman for Wells Fargo, said, "The service was designed to get customers through emergency situations, not to solve their long-term credit needs."

She added: "We want to help them through all their different financial needs. We believe that this is an important service to offer because of the need for short-term, low-sum credit quickly."

Spiral of debt?

A 2011 report by the Responsible Lending group on "Big Bank Payday Loans" found that 44% of customers' next deposits go to repay their loans. Advance direct deposit loan customers are in debt for an average of 175 days, nearly twice as long as the 90-day maximum recommended by the Federal Deposit Insurance Corp. for high-cost debt. "This large proportion no doubt contributes to the long-term debt cycle experienced by many payday borrowers," the report says.

Payday loans charge as much as $17.50 per $100 loan with repayment often due in 10-14 days and the equivalent of APRs in the middle to high triple digits. Seventeen states, including Arizona, New York, New Jersey and Ohio, plus the District of Columbia, have limited interest rates to 36%, and passed other restrictions on short-term loans. A federal law placed a similar cap on loans to service members.

"Banks say advance deposit loans are not a payday loan," says Day from the lending advocacy group, "But everything acts like a payday loan. It's exactly the same thing."

"It's a debt trap," says Kelly Griffith, co-director of the Southwest Center for Economic Integrity, a Tucson, Ariz.-based research, education and consumer advocacy group. "If you can't make money with a 36% gap, then you shouldn't be making that kind of loan."

Closer federal oversight

Richard Cordray, the director of the federal CFPB, which oversees financial products, said in January 2012 his agency would be "paying close attention to deposit advance products at the banks that offer them."

He spoke at a special hearing on payday lending held in Birmingham. The CFPB issued a field guide -- "Short-Term, Small-Dollar Lending Procedures" -- for the agency's examiners as they look at how banks and payday lenders "conduct business." Cordray said the examination would include "looking at the materials and strategies that are used to market the loans."

Representatives for Wells Fargo, Fifth Third and Regions banks say that they're offering a valuable service for consumers. All five banks currently offering advance direct deposit loans outline in their online marketing materials that consumers should think carefully before choosing this loan option.

Wells Fargo had safeguards in place that required balances to be paid off before consumers could borrow again, says Messick. Wells and other banks also include "cooling-off periods" for individuals who have borrowed money on these types of loans for six consecutive months.

Regions Bank spokeswoman Evelyn Mitchell said that her company offered its Ready Advance product in response to customers, many of whom were already using a nonbank, advance loan product. She said that Ready Advance was designed to meet the occasional and immediate credit needs of existing Regions Bank customers who have had a checking account in good standing for at least nine months.

Better than payday loans?

Compared to payday loans, the bank-sponsored advance loans may be better alternatives, says Brian Melzer, a finance professor at Northwestern University's Kellogg School of Management. Melzer has researched the negative effects of payday loans. He found that households with "better access to payday loans are more likely to report financial distress."

Melzer says the advance deposit loans may be a better choice for those families because the fees are lower than payday loans, and banks have the resources to monitor the loans more closely.

Still, he "puts the advance deposit loans in the same category as payday loans." Melzer says that the most effective way to handle small financial emergencies is by avoiding them through more careful money management.

"You have to budget better and accumulate a buffer of savings so that when you get expenses, you have enough to cover them," Melzer says. "Then you'll be able to make it through."