How to Money, Episode 6: What is a Payday Loan?
It’s October, which means it’s time to get a little scary. That’s why our new episode of How to Money is focused on one of the scariest financial products there is…
What’s a payday loan?
Payday loans come with very short repayment terms—averaging only two weeks in length—and APRs that are ridiculously high—even in comparison to other kinds of bad credit loans.
If you’re not careful, a payday loan could trap you in a cycle of debt. We’ll talk more about that below.
Due to their short terms, high rates, and the higher likelihood that borrowers will become trapped by their debt payments, payday loans are generally considered to be a form of predatory lending.
How do payday loans work?
Payday loans are small-dollar loans, usually around $300-400. In contrast, the average personal loan balance in 2017 was $7,603, according to TransUnion.
With a traditional payday loan, the only thing you need to secure the loan is a postdated check for the amount you borrow, plus interest, that you give to the lender. They then cash the check on the loan’s due date.
(Many payday loans nowadays are online loans. Online payday lenders often opt to automatically withdraw the funds directly from your bank account.)
The idea behind payday loans—with the short terms and low principals—is that they are only supposed to last you until your next payday. But the reality is something different and is something much, much scarier.
Let’s say you take out a 14-day payday loan with an interest rate of 15 percent. Sounds reasonable right?
Well, that loan’s interest rate doesn’t look so good when you compare it to the rates for other, longer-term loans.
The best way to measure a loan’s cost in comparison to other loans is to measure its annual percentage rate or APR.
Now, remember, that payday loan’s 15 percent interest rate only applies to a period of 14 days. If you measure how much it would cost over the course of one year, you get an APR of almost 400 percent!
But is that what your typical payday loan looks like? Well, if you believe this 2013 study from the Consumer Financial Protection Bureau (CFPB), then, yeah, that’s exactly what it looks like. They may not be as expensive as credit card cash advances, but they’re still way more expensive than your standard personal loan.
It’s those high APRs and short repayment terms that can lead many payday loan borrowers to get trapped in a dangerous cycle of debt.
(Many of these traits are also shared by title loans, another type of lending that’s widely thought of as predatory.)
The payday debt cycle.
There’s one other element that plays into the predatory debt cycle, and that’s lump-sum repayment.
Basically, payday loans are designed to be paid back all at once. This is different from installment loans, which are structured to be paid back in a series of smaller, regularly scheduled payments over time.
Combining lump-sum repayment with short loan terms means that many payday loan customers can’t pay their loan back on time.
Think about it. If you had two weeks to pay back 345 dollars, could you?
Some people then roll their loan over, extending their due date in return for paying more interest. With loan rollover, you get another two weeks to pay back the loan, but you have to pay the interest fee on an additional loan term. (It’s illegal in many states.)
Other people pay their loan back in full and then immediately take out a new one to cover other expenses. That’s because they paid it off using money that they needed to use on rent or their gas bill or on groceries.
How often is this kind of stuff happening? Well, according to another CFPB study [PDF], over 80 percent of payday loans are rolled over or followed by another loan within 14 days.
Either way, people just keep extending or reborrowing their payday loans, racking up more and more interest, all the while never getting any closer to paying back the loan principal and actually getting out of debt.
That is how the debt cycle works, and that is why most people consider payday loans to be a form of predatory lending.
Here Are Your Takeaways
- Payday loans are short-term, small-dollar loans with very high APRs.
- Their payment terms often lead to loan rollover and reborrowing.
- They can easily trap people into an unending cycle of debt.
- Do not take out a payday loan.
If this your first time watching How to Money, you should check out our other How to Money episodes, where we cover secured loans, the debt to income ratio, and more! You can request topics for future How to Money episodes by emailing us or by shooting us a tweet at @OppLoans.
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