Installment Loans: More Mileage for Your Money (Part 2 of 3)
If you were planning a long road trip, would you rather have a dependable minivan or a sweet F1 racecar? Sure, that racecar sounds fun, but in this hypothetical, you actually want to arrive at your destination, not blow up or break down before you even leave town.
The same holds true if you’re looking to take out a loan. Think of your finances like a long road trip, not a quarter-mile street race. You’re going to want a loan that will get you to your destination and keep you safe along the way.
If you’ve ever looked for an online loan, you’ve come across payday lenders. These predatory lenders advertise their short-term “payday” loans as a quick solution to get you through to your next paycheck. A fast, two-week loan might sound like it’s not too dangerous, but look under the hood and you’ll see these “short-term” payday loans aren’t so short-term after all. And it’s all due to a hazard called loan rollover.
Like a Rolling Loan
When a borrower can’t pay back their payday loan in time, they’re given the option to roll the loan over, which means that the loan gets extended for another term. It gives the borrower more time to pay off the loan, but it also allows the lender to charge another round of interest and fees. So now, that “short-term” loan has gone from a term of two weeks to four, and the borrower owes twice as much they expected they would.
Here’s an example: Dale takes out a $300, 14-day payday loan with an interest charge of $45. When the time comes for Dale to pay the $345 he owes on the loan, he doesn’t have the money. So he rolls the loan over. Dale pays the $45 he owes in interest and gets another 14-day repayment term. However, Dale will also owe another $45 on this new term, and will pay $90 in interest overall. As you can see from this example, rolling over a loan increases the cost of borrowing.
This isn’t the only kind of rollover. There’s also reborrowing. When a person reborrows a loan, they aren’t actually getting an extension on their repayment term. Instead, the borrower pays off their loan in full and then immediately takes out a new loan. Either way, the effect is the same: paying more money to borrow the same amount of money.
This is the Loan that Never Ends
Think about it like this: you’re taking a day trip from New York to Philadelphia to meet your friend, Danica. But once you arrive in Philadelphia, Danica hits you with a text; turns out she’s not in Philadelphia anymore. She’s in Pittsburgh. So then you drive all the way to Pittsburgh, only to find out that Danica’s not in Pittsburgh anymore. Now she’s in Chicago. You keep driving, and Danica keeps moving, and by the time you two meet up it’s in Los Angeles. No matter how much gas money you had budgeted for this trip, you would end up spending far more, right?
That’s pretty much how rolling over a payday loan affects the cost of borrowing. The longer a payday loan is outstanding, the more expensive it becomes. And according to 2014 study from the Consumer Financial Protection Bureau (CFPB), a mind-blowing 80% of payday loans are the result of rollover or reborrowing. Another CFPB study found that the average payday loan borrower took out a staggering 10 loans per year and spent almost 200 days per year in debt. What was that about “short-term loans?”
Installment Lending Can Go the Distance
Let’s return to our original question: F1 versus minivan. If you were driving from New York to Philly, you might pick the F1. Sure it only gets 4 miles to the gallon (mpg), but the trip isn’t that long. However, if you had known you were driving to Los Angeles in the first place, you’d have picked the minivan. It gets a much more fuel-efficient 35 mpg, so driving it cross-country won’t cost you a fortune.
The same is true for installment loans. Like a minivan, they are designed to be more efficient and cost-effective. An installment loan is clearly the better choice.
To learn more about the benefits of the installment loan model, check back tomorrow for Part III of this series! Also see What is the Payday Loan Debt Cycle? in our Blog for more information about payday loans.
- Burke, K., Lanning, J., Leary, J., & Wang, J. (2014, March). CFPB Data Point: Payday Lending. https://files.consumerfinance.gov/f/201403_cfpb_report_payday-lending.pdf
- “Payday Loans and Deposit Advance Products.” (2013, April 24). Retrieved from https://files.consumerfinance.gov/f/201304_cfpb_payday-dap-whitepaper.pdf