Payday Loans vs. Overdraft Fees: Let’s Break it Down

Inside Subprime: Nov 20, 2018

By Jessica Easto

Let’s look at a common scenario that 40 percent of American adults experience… You’re low on funds but still have a few monthly expenses to pay: your car payment, the electric bill, and a week’s worth of groceries for your family. You’ll need about $500 to take care of the bare essentials and get by until your next paycheck.

In these all too common situations, you might turn to payday loans—a short-term, high-interest, small-dollar loan advertised as emergency funding to tide them over until their next paycheck when they can pay it off. You head over to your nearest payday lender—the companies that promise “FAST CASH NOW”—and write them a check for $500, the principal, plus interest and fees. You postdate the check for your next payday (usually within two weeks), and walk out with $500. When payday rolls around, the payday lender cashes your check and your debt is repaid. That’s why payday loans are often referred to as “cash advances.”

That sounds pretty painless, especially when it means putting food on the table. But things that sound too good to be true usually are. Remember, payday loans are high-interest loans—a typical payday lender charges $15 for every $100 dollars borrowed. That means your $500 loan actually costs you at least $75 and likely more when you factor in additional fees. That works out to an annual percentage rate (APR) of more than 400 percent, a typical rate for payday loans. (Compare that to credit cards, which typically have an APR of less than 20 percent.) Plus, you only have two weeks to pay for it.

If you can come up with the money in time, a big chunk of your next paycheck is gone before you see it, which doesn’t put you in the best position for next month’s money management. You could very likely end up where you started: in line at the payday lender.

If you can’t pay for it—like 20 percent of payday borrowers—your lender may let you “rollover” your debt. This means you get to extend the term of the loan by paying off the old interest, additional interest, and additional fees. Now you’ve paid at least $150 for your $500 loan.

This is a major risk you take with payday loans: getting yourself in a debt trap that’s hard to get out of. That’s why payday lenders are often considered predatory—the exploit vulnerable populations with what is essentially a scam.

But what if you decide to forgo the payday loan altogether and simply overdraft your bank account? If you opt in to “overdraft protection” and take out more money than you have in your checking account, you are able to complete your transaction for a fee, as opposed to it being declined. All banks are different, but the most common overdraft fee is $35. In a sense, an overdraft is kind of like a cash advance from your bank.

Usually, it doesn’t matter how much you overdraft—$1.50 or $50 results in the same $35 fee, and you are charge the fee every time you overdraw. That means if you take out $20 that’s not there in the morning, and then another $20 that’s not there in the afternoon, you’ve already racked up $70 in fees.

One study by the Consumer Financial Protection Bureau (CFPB) found that most overdraft fees occur on withdrawals of $24 or less. They calculated that if a person “borrowed $24 for three days and paid the median overdraft fee of $34, such a loan would carry a 17,000 percent annual percentage rate (APR).”

Overdraft fees are a big revenue stream for banks. In 2017, Americans paid $34 billion in overdraft fees. In some cases, you may even be charged additional fees for not correcting your balance within a certain timeframe. Additionally, overdrafters rarely overdraft only once. According to one PEW study, most overdrafters paid three or more penalty fees. Banks vary on how many fees they allow to be charged per day (some are unlimited) and on the max amount of fees per day (some are unlimited).

Payday loans and overdrafting are never good solutions when you are short on cash. There are reputable organizations that offer installment loans. But to truly minimize your risk of payday loans and overdrafts, you should learn more about how to manage your finances and avoid predatory lending scams.

For more information on scams, payday loans and title loans, check out all of our state-by-state Financial Resource Guides.