If you’re a little short on cash and need to meet an important expense, a payday loan may seem like a viable option. Be cautious, though. The fees and interest typical of payday loans make…
If you’re a little short on cash and need to meet an important expense, a payday loan may seem like a viable option. Be cautious, though. The fees and interest typical of payday loans make them expensive in the best of circumstances. If you’re unable to repay the debt quickly, the costs can escalate and deepen financial troubles.
Before turning to a payday loan for relief, know how they work and what your reasonable alternatives are.
How Payday Loans Work
Payday lending is permitted in 37 states, according to the National Conference of State Legislatures. The loans allow people to take a cash advance from an upcoming paycheck. The loan amount is small, the repayment term is short and qualification is easy.
To obtain a payday loan, you can visit a store that offers them or apply via phone or online. The sum you can borrow depends on the state you live in, but loans of up to $500 are most common. You will need to be of adult age, have a valid form of identification, a checking account, proof of income and a phone number.
If you go into the store, you’ll write a personal check to the business for the amount you want plus fees. Apply online or over the phone and you’ll give the lender authorization to debit the funds from your bank account. In either case, the lender will add a fee, which is usually limited by law to $15 to $30 for every $100 borrowed. The money will be delivered to you in cash deposited into your bank account quickly.
Then it comes time to make good on the debt. Loan terms are typically two to four weeks, and if you pay it all back by that date, you’re done. If you don’t have all the money, you may be able to extend the loan.
In some states, lenders can renew the loan, allowing borrowers to pay only the fee balance and extend the due date with another fee. For example, if you borrowed $400 and the fee was $60, it will cost you an additional $60 to roll the debt over for two more weeks. At that stage, you’ll have paid $120 to the lender before you’ve paid the original loan amount.
Knowing how much it will cost to borrow against your paycheck should raise a red flag, but seeing how the fees translate into an annual percentage rate might shock you.
To figure out the APR, the interest rate and fees must be compared to the loan amount, and then calculated over a one-year period. Here is an example:
— Principal loan amount: $400
— Interest amount/finance charge: $60
— Repayment term: 14 days
1. Divide the interest/finance charge by the loan principal: $60 / $400 = 0.15 2. Multiply result by 365, for the number of days in a year: 0.15 x 365 = 54.75 3. Divide that result by the length of the repayment term: 54.75 / 14 days = 3.910 4. Convert into APR by moving the decimal point two spaces to the right: 391 percent APR
That means the APR for the $400 loan with the $60 fee is approximately 391 percent. But credit cards designed for borrowers with fair credit typically have an APR of about 25 percent.
Other penalties can also pile on. If the check is deposited, but you don’t have the funds to cover the withdrawal, your bank will probably hit you with a nonsufficient funds fee, which is typically about $30 or more.
Worse, a 2014 Consumer Financial Protection Bureau study found that four out of five payday loans are renewed within 14 days. Most borrowers renew their loans so much that they pay more in fees than the original loan amount.
For these reasons, Scott Astrada, federal advocacy director for the Center for Responsible Lending, warns against borrowing from your paycheck at all. “Once you take the first, you’re already one foot in the quicksand,” says Astrada.
Why You Might Want a Payday Loan
Of course, there are situations when payday loans can be helpful, says Steve Rhode, a consumer debt expert and author of “Eliminate Your Debt Like a Pro” and “The Path to Happiness and Wealth”. “For example, if you need cash for a very short period of time and you know can pay it off in full with your next paycheck and can make ends meet moving forward, then it could be something to consider.”
Typically, payday loans are used to cover a crucial bill. According to Astrada, payday loan business ramps up at the end of the month, when people are facing an upcoming rent payment. In the middle of the month, anxious consumers with empty bank accounts will borrow to keep their lights on and phone service activated. If they have pressing health care expenses, they’ll borrow at any time of the month.
A simple budgeting shortfall can also lead you to a payday lender. Alejandra Perez, a San Francisco resident who received payday loans when she was not as financially savvy as she is today, says, “I was young, and many times I would spend my money on partying. Once I came around to paying bills, I was short on cash. It was useful, but in the back of my mind, I felt bad because I knew the interest rate was very high.”
While the very rare payday loan can be a way to stave off a financial emergency, it should never be used when you can’t afford to pay what you owe in two weeks. Without the funds, the payday loan itself will become a nightmare, says Rhode. The fees will continue until you can pay the balance, and if you default, the lender may sue you. If you lose the case, you’ll be left with a monetary judgment that’s potentially bloated with court costs and a possible wage garnishment.
In general, payday loans aren’t reported to credit bureaus unless the debt is referred to collections. Collection accounts can have a negative effect on your credit score. You may receive collection calls, and if you don’t pay, a collector can sue you just like the lender can.
Laws and Rules of Payday Loans
Payday lenders do have to abide by both federal and state laws. As required by the federal Truth in Lending Act, payday lenders are required to disclose the dollar amount of the finance charge and the corresponding APR in writing.
The CFPB implements and enforces federal regulations, including the Payday Rule. The intention of the law, which has been challenged by the payday loan industry, is to impose strict restrictions on payday lenders. It requires an affordability test and limits rollovers as well as the number of times a checking account can be debited.
Many payday loan users are in the military. A 2018 Javelin Strategy & Research report found that 44 percent of service members received a payday loan in 2017 compared with 7 percent of all consumers. The Military Lending Act prohibits payday lenders from charging military members more than 36 percent interest.
Each state has its own controls over the practice, too. Some, like New Jersey, prohibit payday lending entirely, and others, such as Washington, limit the number of times per year a person can take out a payday loan. A few states have capped the interest rate. In Oregon, for example, a payday lender can’t charge a finance rate of more than 36 percent.
Payday Loan Alternatives
Due to their prohibitively high cost and strong potential to make matters worse, payday loans should always be a last choice. If you’re desperate for a small amount of money, you may have more alternatives than you realize, says Rhode.
Among the options:
— If you’re behind on a utility bill, ask the company about its hardship plan. You may be able to stretch out a payment or be eligible for a plan where your payment is covered entirely, such as Pacific Gas & Electric’s REACH program, which provides an energy credit of up to $300.
— Ask your landlord for an extension on your rent. Maybe you can pay less this month and then make up the rest of what you owe over a few months.
— Use your credit card. Although the APR could be high, it’s typically less than a payday loan.
— Borrow from a friend or relative. Be sure to draw up a contract and stick to it, otherwise you’ll risk harming a valued relationship.
— Pawn or sell unnecessary valuables.
— Tap into your 401(k). You can borrow up to $50,000 if your vested balance is at least $100,000, or 50 percent of the value, whichever is less.
— Pare your budget down to the very basics. If you eliminate excess spending, you may be able to squeak by without a loan.
— Increase your income. Driving for a ride-sharing company, walking dogs and babysitting are just the beginning of ways you might be able to add a few hundred dollars to your wallet in a short period.
— Ask your employer for an advance on your paycheck. Under extreme circumstances, it may be allowed and could be a fee-free method to borrow against your future income.
— Do without. Weigh the importance of what you need the money for and question whether or not it’s truly required.
— Turn to a federal credit union. Many have payday alternative loans, and they’re bound by law to charge no more than 28 percent interest.
Finally, when assessing a loan of any kind, know the difference between one that builds wealth, such as those for an education or a business with reasonable terms, and loans with fees so high they almost immediately become a drain on your resources. “The fact is, payday loans leave many consumers in a debt trap,” says Astrada. “There’s just no way to justify an APR that’s in the triple digits.”