Sometimes people get in a severe cash crunch and desperately need to raise money quickly. It could be an emergency car repair, a check that bounced or a bill that absolutely must be paid – in a month when they're maxed out on their credit cards. That's when it's easy to stumble into the not-so-hidden world of payday loans and risk getting much deeper into debt remarkably quickly.
What is a payday loan, exactly? Payday loans are loans that are given out for relatively small amounts of money (usually less than $1,000) for short periods of time. The idea behind a payday loan (also know as a “cash advance” or a “check loan”) is that it gives you some cash to tide you over until the next payday, with the idea that you will use your future paycheck to pay it off.
The payday loan industry now amounts to a $38.5 billion market, according to the Wall Street Journal, especially in the 32 states that don't put a lid on how much lenders can charge (see In what states are high-cost payday loans illegal?). And it's about to be hit with a new series of regulations from the Consumer Financial Protection Bureau (CFPB) .
The Proposed Rules
Payday loans typically have an average annual percentage rate of roughly 390%, according to the CFPB. Loans not repaid quickly can balloon to hefty multiples of the original sum, with with more than four-in five single-payment loans reborrowed within a month, incurring additional fees.
The new rules would set up a "full payment test" requiring lenders to establish that teh borrower can afford to make the payments and still pay basic living expenses and other costs, make it more difficult for lenders to refinance the original loan and regulate penalty fees. Click here for details.
Consider the Cost
Payday loans usually require access to your checking account to deposit the loan and later to access the repayment funds. They are a way for people with poor credit (or no family or friends they want to tap) to gain quick access to cash in a pinch – it usually only takes a few hours to a few days to get the loan approved.
Despite the speed of getting funds in an emergency, payday loans are not a good financial decision for many reasons.
Though the CFPB study found an average annual percentage rate (APR) on payday loans to be 391%, it can be as high as 2100% (yes, you read that number correctly). For reference, the highest APR allowed for credit cards is 29.99%. When borrowing money, you should always borrow from the source with the lowest APR possible; this will decrease the amount you pay in interest.
Figuring out the amount of interest you are paying isn’t always so clear. For one thing, an APR is calculated on a yearly basis. A typical payday loan lasts one to four weeks, and the cost is not given to you in annual terms. In fact, payday lenders may refer to the cost of borrowing money as a “fee” rather than as interest, which makes it seem like it is something you have no control over. Comparing apples to oranges masks how much you are paying for a payday loan compared to other sources of money, such as credit cards.
How They Work
Here’s how a payday loan works: You pay a “fee” for borrowing money at a set rate. This fee is usually between $15 and $30 for every $100 loaned. This sounds reasonable – just 15% to 30% – but because it is for a short period of time it is actually much higher than a credit card charge for the same amount. If payday comes around and you can’t afford to pay off the original loan plus the fee, you can “roll over” the loan … for another fee. This can snowball expenses for the consumer. The goal of a payday loan enterprise is to keep making money – lots of it.
According to the Consumer Finance Protection Bureau, 82% of loans are rolled over within 14 days, and half of all borrowers end up paying more in fees than they originally borrowed.
To make things worse, if the borrower provided a bank account number to the lender, the lender will make an automatic withdrawal of the amount owed, sometimes in multiple withdrawals with a fee for each withdrawal. If the money isn’t in the account, you pay the rollover fee and you also pay bank overdraft fees.
There are many loopholes in the payday loan business and few protections for consumers. Many states set limits for loan rollovers, but don't limit opening a new loan on the same day that the old loan is paid off. Some states have a 24-hour waiting period for new loans, and some states have no restrictions whatsoever.
Members of the U.S. military have some protection under the Military Lending Act. Active duty military members, their spouses and some dependents have an APR cap of 36%, and they are protected from paying more fees due to rollover charges.
While there are still many brick-and-mortar payday loan centers, many payday loan operations have moved online. This has opened up many opportunities for scams that can be difficult to recover from. If you think you are the victim of a payday loan scam, contact the Consumer Finance Protection Bureau to file a complaint.
Alternatives to Payday Loans
While the prospect of quick cash for a fee may be appealing, it is almost never worth the risk of being caught in the payday loan trap. Although some websites advertise payday loans as a way to build your credit, it is an expensive and risky route to take. Before taking out a payday loan, ask yourself: "If I can’t afford my expenses with my current paycheck, is there any reason I will be able to pay back a loan plus fees – and cover my normal expenses – when I get my next paycheck?"
If the answer is no, consider some alternatives to a payday loan:
- As already mentioned, credit card interest rates are lower than you'd pay for a payday loan. If you have access to credit or credit card cash advances, choose those resources over payday loans. See if you can open a new credit card or increase your limits on current cards.
- See if you can get a small loan from a bank or credit union. Small and short-term loans have become more common as banks and credit unions provide alternatives to payday loans for their customers.
- For fast cash, try selling some of your belongings or pick up a side job (even a night of babysitting may tide you over). See Make Money Fast From The New 'Sharing Economy' for some other ideas.
- If you routinely find yourself unable to make your funds last until the next paycheck, make a budget and decrease your expenditures.
- To avoid getting in a pinch in emergencies, build an emergency fund so you won’t have to take out loans for unexpected expenses.
- If you already have a payday loan, get overdraft protection on your bank account.
The Bottom Line
Payday loan borrowing can be an expensive cycle that is difficult to break. The industry is designed to take advantage of people with limited resources, and the consequences of taking out a payday loan can be many times more costly than the initial expense. If you are in debt and struggling to make ends meet, consider getting financial counseling to find a way out of your tight circumstances.
The new rules will cover payday loans, auto title loans, deposit advance products and certain high-cost installment and open-end loans. Comments on the new rules are due on September 14, 2016, and "will be weighed carefully before final regulations are issued," said the CFPB. Click here for various ways to submit comments.