The Payday Loan Trap
What Are Payday Loans?
Payday loans are small, short-term loans with extremely high interest rates. The lender gives you cash and you either write a personal check payable to the lender for the amount you want to borrow, plus a fee, or you authorize an electronic withdrawal from your checking account on the due date. The loans are for short periods of time: one to four weeks.
What Are the Fees for Payday Loans?
Fees charged for payday loans are usually a percentage of the amount borrowed or so much for every $100 you borrow. If you extend or “roll-over” the loan, you’ll pay additional fees each time. The fee may not sound too bad, but studies show that interest rates on payday loans range from 390% to nearly 900% and that most lenders don’t quote accurate interest rates.
Let’s say you want to borrow $300 until your next paycheck. You write a personal check to the lender for $345 (the $300 you borrowed plus a $45 fee). The lender gives you $300 and agrees to hold your check until your next payday or other agreed-upon date in the very near future. When that date arrives, either you redeem the check by paying the $345 in cash, or the lender deposits your original check. You may also roll over the check by paying a fee to extend the loan for another two weeks. If you don’t have the money in your account to cover the check you wrote, you could incur bank fees for bounced checks.
What’s the Problem With Payday Loans?
These cash advance loans are a very expensive method of obtaining short-term credit. In the above example, the cost of the initial loan is a $45 finance charge for two weeks, the equivalent of $1,170 for a year, or 390 percent APR (annual percentage rate). Even worse, many people find they’re in no better financial shape when the loan becomes due than they were when they borrowed the money, and they get caught up in a vicious cycle of constantly taking out and extending payday loans, which becomes exorbitantly expensive. The lender counts on the fact that most people won’t have the money to repay the loan plus the fee when they get their next paycheck, and will be forced to extend the loan for an additional fee, creating a snowball effect.
If I Need Cash Immediately, What Are the Alternatives to Payday Loans?
Payday loans are not the only way to get through a short-term cash crunch. Consider these better options suggested by the Federal Trade Commission (FTC) before choosing a payday loan or similar loan using a different name:
- When you need credit, shop for it. Compare the Annual Percentage Rate (APR) and the finance charge, which includes any fees, and choose the offer with the lowest APR.
- Consider a small loan from your credit union or bank.
- Ask your employer for a pay advance.
- Ask your family or a friend for a loan (not something I usually recommend, but a better alternative than payday loans).
- Even a cash advance on your credit card may be a better alternative, although it will probably cost you more than the other options listed here.
- Ask your creditors for more time to pay your bills, and find out what that will cost you in fees or interest.
How Can I Avoid the Need for Emergency Short-term Loans Like Payday Loans?
- Make a realistic budget, and figure your monthly expenditures. Avoid unnecessary purchases – even small items add up. Build some savings to avoid borrowing for emergencies or unplanned expenses, even if you can only put away small amounts. For example, by saving the amount of the fee that would be paid on five average $300 payday loans in a year, you could have an extra $300 dollars available to act as a buffer in short-term cash emergencies.
- Talk to your bank about getting overdraft protection on your checking account to protect you from incurring fees for bounced checks.
- If you find yourself having short-term cash problems on a regular basis, or if you need help developing a budget or paying off debt, make an appointment with a consumer credit counseling service.
- If you decide you must use a payday loan, borrow only as much as you can afford to pay with your next paycheck and still have enough to make it to the following payday.
The Bottom Line on Payday Loans
Spending more than you earn is always a bad thing, and payday loans are a bad and expensive “solution” to money management problems. Payday loan companies take advantage of your need for cash and rake in billions of dollars a year in fees, at your expense.