If you're lucky, you might not be familiar with the term "payday loan". A payday loan is supplied by a third-party lender and it is supposed to help consumers get out of last-minute financial jams by offering a cash advance on an upcoming paycheck. While getting out of a tough spot is certainly a good thing, the interest charged by payday lenders typically surpasses 100%, which could make a tough spot even tougher. So, are payday loans a great service for those in need, or are they an example of loan shark companies preying on people's desperation? We will get to the bottom of it in the following article. (Keep your credit score healthy and your debt under control, check out Six Major Credit Card Mistakes.)
Why wait for payday?
A payday loan works like this: You're short on cash and can't wait until your next paycheck comes around, so you head off to your local payday lender (some of whom are even online these days), and ask to set up a payday loan - usually somewhere between $50 and $1,000, although the higher limits are usually harder to qualify for. You write a post-dated check for that amount plus the fees you now owe to the lender. You get your money right then and there and, when payday rolls around, the lender will cash your check and collect its profit.
Typically, people who use payday loans find themselves in situations where they are presented with few other financial alternatives. In their eyes, a payday loan is a way of staying afloat for a short period of time without having to ask for handouts. People with low credit or no credit are ideal customers for payday lenders. (To learn more, see The Importance Of Your Credit Rating.)
One Step Forward, Two Steps Back
In most cases, a payday loan is not an attractive option for short-term financial problems. Exorbitant interest charges, sub-par lender reliability, small loan size, future dependency and the possible negative effects that borrowing from these lenders can have on your credit rating are all valid reasons to avoid a payday loan if at all possible. (For related reading, see Are You Living Too Close To The Edge?)
The amount of interest charged by payday lenders is no joke. Annualized interest of between 200% and 500% are the industry standard. For example, the following chart shows annual interest charges from an $18 fee (essentially the interest) charged on a borrowed sum of $100 from various loan lengths. Payday lenders are often able to get around usury laws - government limits on the amount of interest a lender can charge - by calling their interest charges "service fees", which aren't subject to the same regulations as interest fees are in many places. (To learn more about loan interest and how to calculate it, read APR Vs. APY: How The Distinction Affects You.)
|Day of Loan||Finance Charge per $100||APR*|
|*Per Truth in Lending Act|
Above the Law
Many states have usury exemptions for loans made by foreign entities, or lenders incorporated outside the borrower's state. When a state won't accept the "service charge" loophole, lenders will often take advantage of this by setting up shop in places with no restrictions on the amount of interest they can charge. A lender in South Dakota, where there is no usury limit, can make a loan to someone in California, where usury restrictions do exist, by taking advantage of this trick. The excessive interest charged by payday lenders is illegal in many places, including Canada, where usury is technically limited to 60%, although the Canadian government has yet to step in to enforce the law. Of late, many states have been taking steps to bar payday lenders from operating within their borders.
In general, payday lenders tend to be less reputable than their commercial bank counterparts. In an industry where documentation is paramount, payday lenders can require borrowers to provide personal financial and identification information as part of their approval process. Because payday loans provide big profits for lenders without many requirements for professional credentials, a lack of information security and potential for fraud are also troubling aspects of payday loans. (Find out how to protect yourself and your loved ones from financial fraudsters, read Stop Scams In Their Tracks.)
With all the detractors from the payday loan, the size of most payday loans seems of little consequence. But when you consider the fact that most payday lenders won't typically authorize anything more than $400, their usefulness - particularly if someone is concerned about keeping up car or mortgage payments - really comes into question. The small loans act in the lenders' favors in more ways than one: Smaller loans means more borrower diversification because spreading money over more customers means less risk. Also, limiting loans to small amounts can often disguise just how extreme the interest rates are.
Learning to Live Without
Another major risk that goes along with payday loans is the risk of dependency. While a payday loan might get you through the end of the month, will the interest charged on the loan make things even more difficult for you the following month? A cycle of dependency like this can cripple a person's financial health. If this is the case, taking out a payday loan can have a lasting impact on your ability to get credit in the future. As payday loans become more commonplace and are being handled by more established companies, some payday lenders are starting to report to credit bureaus. Given the precarious nature of most payday borrowers' finances, defaulting on your payday loan could mean a lasting scar on an already weak credit score. (Recognize when it's time to cut back on spending, read Five Signs That You're Living Beyond Your Means.)
Payday loans are not the only solution to short-term liquidity problems. If you need money and you find that collateral and credit aren't major problems, a conventional loan is the best-case scenario. If taking out a personal loan isn't a realistic possibility, asking your employer for a pay advance or going to online lending communities like Prosper.com can be a way of avoiding a payday loan. Despite the old adage that warns against borrowing from friends and family, you might want to consider it over resorting to taking out a payday loan - especially considering the payback options put you in a deeper hole. (For related reading, check out Getting A Loan Without Your Parents.)
Resorting to a payday loan is often a worst-case scenario, and you may find that a payday loan is your only option. If this is the case, it's important to weigh your options and reflect on all your facts before you enter into a financial agreement that's probably stacked in the house's favor. You can also work toward building yourself an emergency fund, so that you'll have money available if disaster strikes. In a sticky situation, it could be the best solution of all. (To read about saving for disaster, see Build Yourself An Emergency Fund.)