While They May Seem Like a Lifeline, Payday Loans Are More Likely to Leave You Drowning in Debt
At first glance, payday loans don’t seem like a terrible idea in a pinch. After all, we’ve all been there before.
It’s the end of the month, bills are due, and you think you’ve got your bases covered. But then — almost as if the universe is conspiring against you — smoke starts billowing out from under the hood of your car as the “check engine” light comes on. Fantastic.
You pull over to the side of the road to call a tow truck (and probably let out some expletives under your breath) and think: “How much is this going to cost me?”
Unexpected expenses are a reality many of us are all too familiar with. But what are you to do when such an expense pops up and throws a wrench into your monthly budget? For those with an adequate emergency fund, it’s not necessarily the end of the world.
However, according to data from the Federal Reserve, nearly 40% of Americans don’t have enough in savings to fully cover the cost of an unexpected $400 bill.
So what are you to do when an unexpected expense forces its way into your life? What if you feel you need to borrow $400 now? People find themselves looking to a variety of methods to cover these expenses including carrying a balance on a credit card, borrowing money from family members, or using a payday loan.
But what exactly is a payday loan and why do we keep hearing about how dangerous they are? And why are these loans banned in numerous states and Washington DC? Let’s take a deeper look into how they work, why they’re bad (as in really, really bad), and what some alternatives are for those who don’t have access to credit or traditional loans.
What are Payday Loans and How Do They Work?
Payday loans are not for the faint of heart. They can be difficult to repay and could end up costing you much more than you expected if you’re not careful.
What Are They?
A payday loan is a small and incredibly short-term loan tied to a borrower’s income. These loans are generally for small amounts ($500 or less) and come with radically higher interest rates than other forms of borrowing and are available both via storefronts and online lenders.
Payday loans are often seen as a last resort lifeline and are not intended to cover large expenses like a new vehicle or a home project. Instead, these loans may be used to cover something like an unexpected vehicle expense (but more on the realities of this later).
How Do They Work?
To get approved for such a loan, borrowers provide lenders with proof of income (paystubs for a specified amount of time, dependent on the lender) and authorize a postdated check(s) that coincides with the date(s) they receive a direct deposit from their employer (also a requirement to get approved in most cases). Alternatively, borrowers may actually grant electronic access to their bank accounts to lenders to withdraw payment (more on that later).
After being approved, a borrower will have the funds deposited directly to their account for use. Then, when payday hits, the lender will cash the postdated check for the amount owed plus the interest on top of things — hence the name “payday” loans.
Why Do People Use Payday Loans?
Before diving deeper into why payday loans are a bad idea, it’s important to first understand why borrowers take out these loans in the first place. As mentioned earlier, many American households simply don’t have enough savings to cover unexpected expenses like vehicle failure. But, there’s more to it than that.
Payday loans are unique in that they’re not dependent on the ability of the borrower to pay back a debt but rather on the ability of the lender to collect. Traditional forms of borrowing typically evaluate a borrower’s financial status. Lenders want to see past history of good repayments (like on your credit report) and see that you have ample income to reasonably repay a debt over a specified time.
Unlike traditional banks or credit unions, payday lenders are only interested in their ability to collect the money owed, not your financial position. With that in mind, it’s no surprise payday lenders don’t look at things like your debt-to-income ratio or credit report.
This makes payday loans appear as a lifeline to consumers who don’t have access to traditional lines of credit (credit cards, lines of credit with a bank, personal loans, etc.). People with poor or no credit history can still get access to a short-term loan so long as they’re employed, have a valid checking account, and have a valid ID.
The Bad Parts About Payday Loans
Now that we’ve got the basics of payday loans down, it’s time to start looking at the reasons they’re such a bad idea. There are a variety of reasons so we’ve broken them up into individual sections to explain just how dangerous they can be.
1. The Cost
The first and most obvious issue with payday loans is the cost associated with them. Lenders often disguise high-interest rates as a one-time “fee” for the loan, but the reality is very different.
These so-called “fees” (read: interest rates) range from state to state, but you can expect to pay between $10 to $30 for every $100 borrowed, according to the Consumer Financial Protection Bureau (CFPB). To use a number on the lower end, let’s look at a “fee” of $15 per $100 borrowed.
Assuming you needed to borrow $400 — just $25 above the average payday loan size in the US — it would cost you $460 to repay the debt. Now, $60 to borrow $400 may not sound horrific; that’s 15% and the average credit card annual percentage rate (APR) is 15.09%! That doesn’t sound too bad, right? Hey, you’re beating the interest rate from an average credit card! But there’s more to the story.
That $60 “fee” to borrow the $400 is for an incredibly short-term loan, typically around 2 weeks (your next payday). If we take that fee and adjust it for the year, we’re looking at a rate of nearly 400% for the loan — and it gets worse.
2. Rollovers and the Reality of Payday Loan Borrowers
In theory, a quick short-term loan at 15% may be a helpful last resort for a borrower who can easily repay on time. However, the reality of the payday loan scene is radically different. In states where it’s allowed, borrowers may also roll over a loan if they can’t afford to pay it back in time on their next payday. This is the bread and butter for payday lenders.
To use our $400 example from earlier, the borrower may pay another $60 “fee” to roll over the loan for another 2 weeks instead of paying the total amount owed right away. This $60 charge does not affect the principal whatsoever. What you end up with after just one extension is paying $120 to borrow $400 for a total of 4 weeks (that’s 30% of the amount borrowed after just one extension). Add on a second extension and suddenly you’re at 45% of the amount borrowed. You can already see where this is going.
3. The Payday Loan Cycle
Again, in theory, payday loans aren’t horrendous if you’re able to repay right away, but is that what’s going on? The answer is a resounding no.
According to the CFPB, 80% of payday loans are taken out within two weeks of repayment of a previous payday loan. That’s right, a staggering 8 out of every 10 payday loans are taken out within one pay cycle from a previous loan as most borrowers either renew or reborrow a payday loan.
That’s because many borrowers are not using these short-term loans for what you’d expect. While the concept of a payday loan may make sense for an unexpected expense, the reality is the majority of borrowers aren’t using them for such circumstances.
In fact, according to data from Pew Charitable Trusts, 69% of borrowers use payday loans to “cover a recurring expense, such as utilities, credit card bills, rent or mortgage payments, or food.” When borrowers pay off one loan, it’s likely to leave them short on cash to cover bills and so they end up reborrowing only to end up in a cycle of debt.
4. Access to Your Bank Account
In some cases, borrowers are required to give a payday lender electronic access to their bank account via Automatic Clearing House (ACH) authorization. This isn’t the same as providing your login details, answers to security questions, etc. but allows lenders to withdraw money directly from your account since you’ve already provided permission.
This often seems like a good idea because, like setting up autopay, it ensures you won’t miss your upcoming payment. However, if things turn for the worse and you need to renegotiate your repayment with a lender, the situation can get bad quickly. Lenders may directly withdraw what you owe (plus other fees or charges you weren’t aware of but were in your contract) before you’ve had a chance to discuss other options, leaving you with a negative account balance, costly overdraft fees from your bank, and ending up needing to borrow money again.
5. Payday Loans Won’t Help Credit Scores (But Can Hurt)
Unlike more traditional borrowing practices, payday loans generally won’t help you improve your credit score — even if you pay in full and on time with every loan. Similar to the way medical bills are handled, payday lenders typically don’t report to credit bureaus for those in good standing. Instead, lenders are only likely to report to major credit bureaus when a borrower is unable to repay a loan successfully. That means they can’t help your credit score, but they most certainly can hurt it if things go awry.
6. Predatory in Nature
Payday loans are predatory in nature and often rely on the inability of borrowers to repay on time to remain highly profitable. Investopedia defines predatory lending with the following:
“Predatory lending includes any unscrupulous actions carried out by a lender to entice, induce, and assist a borrower in taking a loan that they otherwise are unable to pay back reasonably. In many cases, a predatory loan is often one that carries high fees, a high-interest rate, strips the borrower of equity, or places the borrower in a lower credit-rated loan to the benefit of the lender.”
All of which sounds right in line with payday lenders who explicitly target individuals and communities with limited options. On the surface, offering relief to marginalized groups isn’t bad, but the terms lenders require borrowers to agree to coupled with absurdly high fees make the practice highly predatory.
Alternatives to Payday Loans
Now that we’ve addressed the main concerns with payday loans, what are you to do in a situation where you absolutely need a short-term loan and have no other options? For these, we’re not looking at traditional forms of borrowing because, if consumers had access to those lines of credit, they wouldn’t be looking at a payday loan in the first place.
With that in mind, here are some options that don’t involve getting stuck in a cycle of unpayable debt due to having a less-than-stellar or nonexistent credit score.
Talk to Your Lender Directly
If you’re experiencing a temporary financial hardship, reach out to your lender directly and ask about setting up a payment plan with installments or asking for an extension. Lenders would much rather hear from you and discuss working something out than to have you default on a loan or miss payments. You’d be surprised how many creditors, utility companies, and lenders are willing to work with borrowers acting in good faith. This should be at the top of the list before exploring potentially predatory loans. Seriously, make the call and work it out before things get out of control.
Ask for an Advance at Work
Again, this one may be a bit of an uncomfortable one, but where else are you going to receive your next paycheck early with 0% interest? Chances are, your boss is like everyone else in this world and has found him/herself in a tight spot financially before as well. This alternative isn’t a loan, it’s an advance. That means your work is the collateral and you can’t expect to get your next paycheck on the next payday so use the money appropriately.
Borrow Against Other Assets Responsibly (Not Title Loans)
If you do have assets you can borrow against like a home or 401(k), then you have another option. Consider looking at a home equity loan or home equity line of credit (HELOC) if you have a mortgage and equity in your home. Similarly, you can get cash for short-term needs by borrowing from your 401(k) retirement account. However, it is not advisable to look to title loans, though they may seem like they fit into this category. Like payday loans, title loans should be avoided at all costs and carry equally high-interest rates, predatory practices, and leave your vehicle susceptible to repossession.
Ask for Help from Family or Friends
Yes, we know this is likely the absolute last thing many people want to do, but the fact remains that it’s still a preferable alternative to taking out a high-interest payday loan. You may need to ask for assistance from friends or family, and nearly everyone’s been there before. However, this brings finances into personal relationships and things can get uncomfortable. If a family member is willing to offer some assistance, you should ensure to repay the debt in full as soon as possible to avoid the strain lending can put on relationships. Tread carefully.
The Bottom Line
When you find yourself in a financial bind and have no other options available to you, payday loans may seem like a good idea. However, after looking at the reality of not just the loans themselves, but the way in which these businesses operate, it’s clear they simply don’t offer the much-needed relief they claim to offer.
Between the absurdly high cost of borrowing, the likelihood of ending up in a never-ending cycle of debt repayment, and the predatory nature of lenders, it’s clear that borrowers should stay far, far away from payday loans. While we all know having an emergency fund and a great credit score can help solve many issues, the fact remains that many people simply aren’t in their ideal financial situation yet. That’s fine — we all have to start somewhere.
However, if you do find yourself in a tough spot, payday loans shouldn’t even be on your radar when there are other options available. Do yourself a favor and steer clear of payday loans so you don’t drown.