Chances are you've been here: just as payday finally rolls around, your rent is due and the dishwasher or water heater — or furnace — calls it quits. If you've been tempted to use a payday loan to get through until your next paycheck, you're not alone. According to a Pew Charitable Trusts payday loans study, 12 million Americans take out payday loans each year, which equates to $9 billion spent on loan fees alone.
In fact, payday loans are a form of predatory lending. Here are some details you should take into serious consideration before applying for this type of loan.
What is a Payday Loan?
A payday loan is a short-term loan that's often issued for a low dollar amount, has an extremely high interest rate, and must be paid off by your next payday — a tight turnaround.
A few things to know up front:
- Payday loans usually have a limit amount of $500, but they can be more or less.
- Payday lending is not legal in some states.
- In states where payday lending is legal, lenders may be required to hold a license.
Payday Loan Interest Rates
As reported by the Consumer Financial Protection Bureau:
- Payday loan annual percentage rates (APRs) are commonly around 400% or higher. To put things in perspective, credit card debt is widely considered high-interest debt and those APRs are only around 12-30%!
- Finance charges are also factored into the cost of payday loans. Fees vary by state, but the average finance charge for a payday loan is $15 for every $100 of loan money borrowed.
So, that low-dollar loan amount? It can escalate. Interest and fees quickly add up — and keep accumulating if you miss payments.
On a positive note, active-duty service members and their dependents have certain protections under the Military Lending Act (MLA), which caps interest rates at 36% for most types of consumer loans (but that's still pretty high).
How Payday Loans Work
The payday loan process is straightforward overall, but if you fall behind on payments, you may likely face problems down the road.
Where Can You Get a Payday Loan?
If payday lending is legal in your state, borrowers can most often go to a physical store to apply for a loan. Another option is to find a payday lender online.
What Do You Need to Apply for a Payday Loan?
In all reality, not much. Financial institution lenders check your credit when you apply for other types of loans, but payday lenders generally don't run credit history checks. You'll most likely need to have your ID, verification of a checking account, and proof of income.
How Do You Get Approved for a Payday Loan?
Upon approval, your loan money can be deposited via direct deposit, check, or cash. Again, you're required to repay the loan by your next payday, which will typically be within two to four weeks from when you receive the loan.
You're required to repay the loan by your next payday, which will typically be within two to four weeks.
How Do You Pay Off a Payday Loan?
To pay back the loan, you can write the payday lender a postdated check with the date of your next payday. This check will be for the full amount of the loan, including interest and any other fees, such as a finance charge. You can also authorize the payday lender to debit the check amount from your bank account.
Keep in mind, if you miss the due date because you don't have the money, the lender can still try to cash your check or withdraw the funds from your account. This can result in overdraft charges and cause you to go into default, which can significantly damage your credit score.
Is a Payday Loan a Good Idea?
Although payday loans may potentially offer a way to work through a financial fix, taking one out is most often a risky move. Most borrowers find payday loans difficult to repay since the payoff period is usually around just two weeks.
In theory, you're just paying a fee to get two paychecks on the same day, but what happens when another unforeseen expense pops up in the interim? If you take a payday loan, you're basically signing up to not get paid again for a full month. This can lead to a cycle of:
- Missed payments
- Taking out consecutive payday loans to try to catch up
- Ultimately staying in debt longer
Payday lenders offer rollover loans for borrowers who miss payback due dates. With a rollover loan, borrowers are given a two-week due-date extension, on a continual basis if needed. Borrowers are still responsible for paying their original loan amount and finance charge, plus an additional finance charge for each rollover.
The Pros and Cons of Payday Loans
Payday loans appear convenient, but there's a price to pay for what may seem like an easier route. For every pro listed, there's a con to counter it, and then some.
|Designed to create a cycle of dependence
|No credit check and no safeguard to keep you from biting off more than you can pay back
|Average APR of 400% or higher
|Short-term repayment periods
|Rollovers and extensions compound the existing loan balance
|Defaulting on a loan (which is a high possibility here) will harm your credit
|Unethical (lenders often deliberately target low-income borrowers)
Payday Loan Alternatives
Borrowers strapped for cash may feel like payday loans are the only option, but there are still a few great alternatives to explore.
When money is tight, setting aside funds for anything beyond rent, groceries, and utilities is challenging, but saving for an emergency fund is one of the best ways to invest in yourself. Building up an emergency fund can help keep you from dipping into your savings or taking on additional debt when unexpected expenses pop up, and they always do. Having three to six months' worth of expenses in your fund is a good rule of thumb.
Having three to six months' worth of expenses in your emergency fund is a good rule of thumb.
Debt Management Plan
A more proactive approach, debt management plans may potentially help borrowers improve financial habits so, ideally, they won't get to the point of resorting to payday loans. These programs are offered by not-for-profit companies and provide borrowers with a way to consolidate debt without taking on another loan.
Borrowers with lower credit scores may want to consider debt management plans because eligibility isn't based on your credit score. Debt management plans may also include credit counseling and education programs to help borrowers manage their money better day-to-day and for the long term.
Build Your Credit
Having good credit is to your benefit, especially when it comes to loans. You can take steps to improve your credit score over time by making on-time bill payments and not taking on unnecessary debt. The higher your credit score is, the more likely you are to get approved for a loan with a lower interest rate and a term that's favorable to your financial situation — a much more financially sound option compared to payday loans.
Cash In on Your Knowledge
Knowing that the cash-in-a-flash convenience of payday loans has heavy financial consequences can help you make different choices when you're in a money bind. Being aware of your options and steps you can take to improve your money management — and credit — can help you meet everyday needs and stay on track toward tomorrow's goals.