Payday loans are never a good idea. They typically carry interest rates in excess of 400%. Four out of five payday loans rolls over and ends up costing a lot more than the borrower expected. They’ve been outlawed in many states, and for those who need fast cash, alternatives like a cash advance on a credit card are almost always the better play.
How Payday Loans Work
Payday loans are also called check loans or cash advances.
For consumers who are strapped for cash, a payday loan can seem like a good solution. Payday loans work by advancing money on someone’s paycheck, government check or other guaranteed deposit. A payday loan company gives the borrower a relatively small amount of money, usually between $100 and $1,000. In exchange, the borrower gives the loan company a postdated check for the amount of the loan plus interest. On the date the paycheck gets deposited, the loan company cashes the postdated check and gets its money back, plus the fee. A typical payday loan fee is $17 per $100 borrowed.
To illustrate this, imagine a guy named John whose truck breaks down and he needs $400 to get it fixed. He’s broke and doesn’t get his paycheck for another week, so he goes into a payday loan office. He shows them a pay stub and writes a check for $468, dated the same day his paycheck will be direct deposited. The loan company gives him $400 cash, and he can now afford to get his truck repaired.
This seems reasonable. John has just paid $68 for the convenience of getting his $400 early enough to fix his truck. That’s 17%, which is about the same as the interest on many credit cards.
Payday Loans and High Interest Rates
The first problem with our example above is, John isn’t really paying 17%. Since payday loans often have short terms of fourteen days, John’s annual percentage rate is actually a stratospheric 442%. That may sound crazy, but at least one payday loan company called Cash Central charges even more. Their APRs can be 700% and higher.
John might still think his payday loan is worth it. Percentages aside, he might think an extra $68 is a fair trade to get his truck back. However, John hasn’t seen the biggest problem with payday loans yet: rollovers.
Payday Loan Rollovers: A Debt Nightmare
The biggest problem with payday loans is rollovers. A rollover occurs whenever a borrower can’t afford to pay the loan back. When that happens, the payday loan company charges another interest fee to extend the loan another two weeks.
For instance, let’s say John’s payday arrives, and he finds he needs the money for groceries and other expenses. He can extend his payday loan for two more weeks, but it will cost him another $68. He may think this won’t happen to him, but statistically, he’s wrong.
A full 75% of all payday loan business comes from rollovers, resulting in $3.5 billion taken from mostly low-income consumers every year. Four out of five payday loans are rolled over, and only 2% of payday loan business comes from non-repeat borrowers. Half of all Payday loan customers can’t repay their loan without reborrowing. The average payday borrower stays in debt for 212 days of the year.
The odds are not in John’s favor. In many cases, a loan of just $200 ends up taking months to pay off, and can run into the thousands of dollars.
Working to Outlaw Payday Loans
Eighteen states and the District of Columbia have outlawed high-rate payday loan lending. At the federal level, legislators have not been successful in eliminating payday loans. However, the U.S. Government has outlawed predatory payday lending to U.S. service members. Rich Cordray, director of the Consumer Finance Protection Bureau, has vowed to continue efforts to reform the payday loan industry. For the meantime, predatory lending through payday loans continues in many areas.
Alternatives to Payday Loans
Consumers who need cash fast should consider almost any alternative to payday loans. For instance, think about the following options:
- A cash advance from a credit card
- A small loan from a credit union or a bank
- Borrowing money from a friend or family member
- A cash advance on a paycheck from an employer
To see how far the damage from a payday loan can go, see the video below.
- CFPB Finds Four Out of Five Payday Loans are Rolled Over or Renewed – Consumer Finance Protection Bureau
- What is a Payday Loan – Consumer Finance Protection Bureau
- Fast Facts on Payday Lending – ResponsibleLending.org
- Payday Lending – How a Short-Term Loan Becomes Long-Term Debt – ResponsibleLending.org
- Legal Status of Payday Loans by State – PaydayLoanInfo.org