Payday Loans: How they Work
What You Need to Know Now About Payday Loans
Payday loans are short-term loans that are often used to get through a rough spot. Unfortunately, there are very few situations in which these loans actually end up being helpful. Before you use one, make sure you understand the costs and risks. This page gives you a quick overview of how payday loans work and ideas on how to avoid them.
What are Payday Loans?
Payday loans are small loans you can use when you are temporarily out of money. Most often, payday loans are short-term loans (two weeks or so) for a modest amount of money (a few hundred bucks). To get a payday loan, you typically write a check for the amount you are borrowing – plus a fee. You might leave the check with the lender, and they cash it once you are ready to repay.
If you can’t repay your payday loan when it comes due, you can sometimes “roll it over” so that the loan is extended. You don’t have to repay it, but fees keep accumulating. Some states regulate rollovers -- either outlawing them or limiting the number of times you can renew.
Payday loans are sometimes marketed as "no credit check" loans. You don't need good credit scores (or any credit history), and getting "approved" is easy relative to more traditional loans. As a result, they are popular with people facing financial difficulty.
Costs of Payday Loans
In general, payday loans are extremely expensive. You end up paying an annual percentage rate (APR) that may be several hundred percents. For example, you might pay a $20 fee to borrow $100.00 for two weeks. The Consumer Federation of America has some nice calculations comparing payday loans to the alternatives. These show that you would pay about 426% APR on a payday loan, but paying an APR above 1000% is not unheard of.
Payday Loan Pitfalls
The main pitfall with payday loans is their cost. Due to extremely high fees, they don’t help you solve the real problem. If you’re having financial difficulties, payday loans can only make things worse. You’re paying a really high rate of interest which means that your expenses are just going up. As a short-term strategy – maybe once or twice in your life, if that – payday loans can get you through a rough patch. For example, you might need an emergency repair for your car so that you can get to work and keep earning income.
As a long-term strategy, payday loans will pull you under.
You can get yourself in trouble if things get out of hand. Bouncing checks that you write to the payday loan establishment can end up on your ChexSystems file and result in overdraft charges from your bank. Banks and retailers may then be unwilling to work with you. The lender may also sue you or send your account to collections, which will ding up your credit. If you keep stretching out payday loans, you'll pay far more in interest and fees than you ever borrowed in the first place. To avoid that problem, learn how to get out of payday loan debt forever.
What About Bank Payday Loans?
Banks have moved into the payday loan industry, most likely in order to earn more revenue. While traditional bank loans (loans that you have to qualify for based on your credit, income, and assets) can be a better alternative, bank payday loans are no better than any other payday loan. They may go by a variety of names, but they’re still expensive and risky.
In fact, payday loans from banks can be even worse than the loans you get at a payday loan store. Why? The bank has access to your checking account, and you agree to let them pull funds from your account to repay the loan. If they want their money (but you still need to make mortgage or car payments) they’ll take it as soon as it's available – before you have the chance to spend it on other important things. When you borrow elsewhere, you might have more control over how and when your money leaves.
This doesn’t mean you should never use a payday loan at the bank; using one of these loans is risky no matter where you get it, and it’s possible that your bank can offer better terms.
Alternatives to Payday Loans
Instead of using a payday loan, consider some alternatives:
- Build up an emergency cash fund in your savings account (sometimes easier said than done)
- Build credit so you can borrow from mainstream lenders (in moderation)
- Keep an open credit card for emergency expenses
- Get a signature loan (or unsecured loan) from your bank or credit union
- Pick up a part-time job for extra cash
- Negotiate a payment plan with your lenders (ask about loan modification)
- Investigate overdraft protection plans for your checking account
- Try peer to peer lending services for a better deal
Are Payday Loans Safe?
These loans can easily turn into an expensive nightmare. If you borrow from a storefront payday loan outfit, your physical safety is probably not at risk in the same way it might be if you borrow from loan sharks. Most mainstream lenders will simply add on fees, contact you to try and collect, and eventually bring legal action against you if you don't pay. The loans are financially dangerous.
Applying for payday loans online is also risky. You never know who you're handing your information to, and some websites have no intention of lending you money. They might be gathering information to sell to other lenders (which means you'll be flooded with calls and offers - which might not be as great as it sounds), or they might be looking for personal information that can be used for identity theft. Especially if you're asked to pay a fee up-front, you might be getting involved in a plain old scam.
Defending Payday Loans
The payday loan industry is not shy about defending itself. They argue that payday loans can be less expensive than bounced check fees and overdraft protection programs. In addition, they argue that payday loans are the best quick and easy way for some people to get money.