Payday Loans Can Cost You Thousands
Payday loans go by a variety of names: payday loans, cash advance loans, check advance loans, post-dated check loans, or deferred deposit check loans. They sound harmless, because in most cases you’re just borrowing money to get you through to pay day, but under the surface they are one of the most destructive loans available. A lot of people get payday loans with good intentions of just bridging the gap before their paycheck arrives so they can keep up on their bills, but what usually happens is they find themselves in a position where they can’t repay the loan in time.
Once that happens the high interest rates start to take their toll. Before you know it you’re having to take out another payday loan just to help you pay off the first, and the cycle continues. This leaves you in a state of financial ruin while everything you make is now going on to fund these high-interest loans.
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. They are generally marketed as emergency loans or a cash advance. Whatever the name, they all work the same way.
How Do Payday Loans Work?
Let’s say you want to borrow $300 until your next paycheck. What you’ll do is 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 be able to roll over or extend 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 overdraft fees for bounced checks.
Essentially, you’re giving the lender a postdated check and in return you get the cash. When the date for the check comes due the lender will cash the check to satisfy the loan, you can come in and repay the loan in cash so the check is voided, or ask for an extension. While convenient, it’s the fees that can really stick it to you.
Payday Loan Fees
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 doesn’t sound bad because payday lenders always express it in a flat fee. In the example above we showed a fee of $45 to borrow $300. But studies show that interest rates on payday loans range from 390% to nearly 900% APR and that most lenders don’t quote accurate interest rates.
Going back to the example above, think about the percentage rate for a moment. A $45 fee on a $300 loan works out to 15% for a two week loan. That would be about 30% per month. When you consider that even the worst credit cards are typically up to 30% per year, payday loans can get out of hand quickly. But it isn’t the initial fee that gets you. If you’re in a pinch paying that $40 or so may save you from even bigger financial issues. But it’s when you can’t repay the payday loan and have to resort to extending it and rolling it over, which incurs more fees, which mean more interest and compounds the problem. This is where you can get into a situation where you’re paying hundreds of percent per year just to borrow a small amount of money.
What’s the Problem With Payday Loans?
These cash advance loans are a very expensive way to obtain short-term financing. 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.
Some say it fills a need, but there’s a reason most payday loan places are located in low income neighborhoods and target those with bad credit scores. The lenders target people who are likely struggling and already living beyond their means so offering easy money is irresistible. The lenders also know that these people probably won’t be able to repay their loans and they are fine with that. Why? Because they charge ridiculous fees that over time offset all of the unpaid loans. Think about it. If you’re paying $45 every two weeks to satisfy a $300 loan you took out the lender will basically break even on your loan in about three months if you keep extending it and paying the fee. The longer you do that, the more fees you pay, and the fatter the lender’s wallet gets
What Are the Alternatives to Payday Loans if I Need Fast Cash?
Payday loans are not the only way to get through a financial emergency. The FTC has a few suggestions to consider before taking out a costly payday loan or cash advance:
- 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. It may be a credit card, line of credit, or loan.
- Consider a small loan from your credit union or bank. If you’re a long time customer they may be willing to help.
- Ask your employer for a pay advance. Not as likely in a large corporate environment, but worth a shot. You may also want to look to see if your employer offers any financial assistance programs.
- Ask your family or a friend for a loan. While I don’t like the idea of borrowing from friends and family, if the amount is small and a temporary need it may be a better alternative than getting taken by a loan shark.
- Even a cash advance on your credit card may be a better alternative. Remember, even the worst cards may have APRs of upwards of 30%, but that’s an annual rate, not a monthly rate like you might be paying with a payday loan.
- Ask your creditors for more time to pay your bills, and find out what that will cost you in fees or interest. Think about what you need the loan for. Is it to avoid a late fee on your phone bill? If you aren’t really late chances are the late fee would be far less than the payday loan fee, and if you talk to them they may even be able to waive the fee for a short time. Decide what bills you should pay first if you can’t afford to pay them all.
How Can I Avoid the Need for Emergency Payday Loans?
- Make a realistic budget and leave room for emergencies. Avoid unnecessary purchases. Even small purchases add up. Remember, some of our greatest money leaks come in the form of small monthly subscriptions. 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. Overdraft fees can be as bad as payday loan fees, so you can save big money there.
- 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. They will talk to you for free and try to help you.
- 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 last thing you want to do is be short and have to resort to extending the loan. That’s where the real troubles begin.
The Bottom Line
Not everyone is in a good financial position, and that’s ok. There are times when money is tight and something comes up, but a payday loan can be more than you bargained for. Payday loan companies take advantage of your need for cash and rake in billions of dollars a year in fees at your expense. The best thing you can do to avoid needing a payday loan is to take a hard look at your budget and make sure you’ve trimmed all of the excess spending. Leave some room for short-term emergencies and put a little money aside in an emergency fund. And if you need to, keep a low interest and low limit credit card on hand for a small emergency. As bad as credit cards are for finances, they are still better than a payday loan in a pinch.
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Filed Under: Debt
About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.