The High Cost of Payday Loans
It’s an enticing come-on: get cash quick before payday so that you can cover an unexpected expense. The signs are bright, the storefronts are well-lit and the ads are cheerful. A payday loan will solve your problems!
And then it will create new ones.
How do payday loans work? They’re regulated on a state-by-state basis, so payday loans in Utah may differ from payday loans in Florida. Most work like this: you go to a storefront payday lender, write a check, and the lender agrees to hold on to the check until your next payday. In exchange, they give you cash in the amount of the check, subtracting a fee for its services. On payday, the lender deposits the check and the loan is paid in full.
So, you might write out a check for $100 and receive $85, the payday lender keeps $15. That may seem like a bargain to get out of a quick jam. But what if you can’t cover the $100 check when it comes due?
A payday loan will solve your problems! And then it will create new ones.
If you can’t cover the loan, the payday lender will probably let you roll it over to a new loan. Go to the lender’s office, pay another $15 and the company will hang on to your check for another two weeks.
If you don’t make arrangements with the lender in time the company will deposit the check. If you don’t have sufficient funds in your account, you’re looking at an overdraft fee from your bank. That’s another $35 or so.
You’ve now paid $50 to borrow $100, and you still haven’t paid off the loan. That works out to an annual interest rate of about 2,500% and your financial problem isn’t solved. What are you going to do?
In many states you’ll find other forms of payday loans. For example in some states payday lenders have to convert your payday loan to a payday installment loan, instead of allowing you to roll the loan over an unlimited number of times. Other states have more or less outlawed payday loans, so lenders offer other types of high-interest personal loans. Many of the loans advertised as payday loans are actually structured as cash advances, lines of credit or mortgage loans.
Online payday loans are state-regulated too, so the types of loans that are available online will be the same as those available from a payday loan direct lender where you live.
The problem of payday loans
The U.S. Government’s Consumer Financial Protection Bureau published a report on payday loans in 2013. They found that the average payday loan size was $392 and the average time outstanding was 18.3 days — a typical payday loan set-up.
Next, the study looked at fees. These are usually set as a dollar amount, but it can be viewed as a percentage of the amount borrowed to find an annual interest rate. The average fee per $100 borrowed was $14.40 in the CFPB study, which works out to an annual percentage rate of 339%.
One problem with taking a payday loan is that it’s usually not a one-time event. The CFPB study found that almost all payday loan customers take out three or more loans over the course of a year. More customers take out 20 or more payday loans a year (14%) than take out only one or two (13%). As a result, the average payday loan customer ends up taking out 10.7 loans per year and pays a total of $574 in fees.
This means that most payday loan customers actually need more money than they can get with a typical payday loan and they are paying too much in interest. It also means that some borrowers are using payday loans to meet regular expenses, not rare emergencies.
And it means that they need a better repayment plan. The typical payday loan schedule doesn’t allow borrowers to pay back their loans and meet their other expenses during the repayment period.
What would help? For many customers a better repayment plan, lower interest rates and financial education.
Before you take out a payday loan
Think about how you will pay off the loan or better yet, think about whether you have an alternative source of funds.
First consider whether you actually need the loan. Can you borrow money from a relative? Pick up some extra work? Cut back on spending? Sell something you don’t need anymore? Would a pawn shop help? You may lose the item that you pawned if you can’t pay back the loan, but then you are free of the obligation to repay it.
Many banks offer something similar to a payday loan called a deposit advance. Because of the potential this has to undermine customers’ finances, fewer and fewer banks offer it now than they did a few years ago. In most cases, the fees are lower than those on payday loans. So a deposit advance is a slightly better option if it is available.
Even better, many credit unions offer small-dollar loans known as payday alternative loans that work like payday loans but have much lower fees. The catch is that you have to be a current customer at a credit union that offers them.
You could take advantage of overdraft protection on your bank account. The fees are high, but they may be lower than those of a payday loan. It’s worth researching.
Once you determine where you’ll get the money, whether a payday loan or otherwise, think about how you will pay it back. How will you avoid rolling over your payday loan? Will an extra two weeks give you time to raise the funds you need? Do you actually need more money and a longer repayment period?
Planning to prevent the need for a payday loan
Maybe you can’t avoid taking out a payday loan. Maybe all this advice about alternatives is fine, but you don’t have an account at a credit union. You don’t have an emergency fund. You don’t have a guitar to pawn.
Okay. But what will you do next time?
The first step is to think about building relationships with different financial institutions that offer alternatives and can help you build your credit rating. Shop around to see what services different banks and credit unions offer. Get a credit card if you don’t have one. If you do have one, think about how you will pay down the balance so that you have enough credit to use the card the next time you have an emergency.
Over time, think about saving money so that you have an emergency fund — a savings account that you can use to cover unexpected expenses.
Life is complicated and there will be unforeseen costs. It’s more likely that your car will break down than it is you’ll win the lottery. A payday loan is about the worst way to deal with expenses.
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