CHICAGO (MarketWatch) – Payday loans are designed as a stopgap for those struggling with budgets. But in many cases, these short-term loans, mired in high interest charges, perpetuate a costly cycle of mounting debt.
A payday loan is like a cash advance on your salary. Marketed as a temporary solution to a short-term setback such as a car repair or emergency medical issues, these loans are usually expected to be repaid in two weeks, the usual payment cycle.
But what happens, according to a recent study by Pew Charitable Trusts, is that most borrowers – around 69% of new borrowers – need the money not for a crisis but for daily necessities. This leads to repeat loans.
“Payday loans are legalized loan sharking designed to put people into debt,” says Kathleen Day, spokeswoman for the Washington, DC-based Center for Responsible Lending. “Why would lending to someone in financial difficulty at outrageous interest rates be considered a good thing?”
Amy Cantu, spokeswoman for the Community Financial Services Association of America, the industry trade group based in Alexandria, Virginia, responds that “consumers need a variety of credit options.” Of the payday loan, she says, “We never said it was the right option for every consumer in every situation, but it definitely has a place.
Typically, a payday lender – usually a check cashing or finance company – gives the borrower the amount needed and charges a fee. The borrower, who must have a current or debit account, writes a post-dated personal check or authorizes the lender to withdraw the amount from the account.
Fees are usually based on a percentage of the loan or the tranches of money borrowed. Payday loans are treated like other types of credit by the Federal Trade Commission and lenders must disclose finance charges and annual percentage rates, which may vary from state to state.
In Illinois, the in-store payday loan fee is $15.50 on a $100 loan, which equates to an annual percentage rate of 404%, according to the industry’s largest non-bank lender, Advance. America, based in Spartanburg, South Carolina. This assumes that the loan is renewed every two weeks for a year, which most states do not allow.
But if the loan is only rolled over three times, for example, the finance charge jumps to $62 for that $100. These fees fuel the nearly $7.4 billion that some 12 million Americans spend each year on payday loans, according to the Pew study. At Advance America, the average loan amount is $375, resulting in an average fee of $55.
When payday rolls around, there’s no extra money to pay off the loan and the cycle begins, according to Pew. If a consumer averages $375 per transaction and does so eight times a year, the average fee of $55 per transaction will total $440. This is assuming the loan is repaid in two weeks. If two of these transactions are repeated three times each, the fees reach $534.
“People are paying a lot more in fees and payday loan fees than they expect,” says Nick Bourke, project manager at Pew. This is true despite prior revelations from the lender, as people don’t always understand what they are getting into.
CFSAA, the industry trade group, however, says fees on NSF checks or missed payments could be significantly higher.
According to the Pew and Advance America study, it takes the average borrower 18 days to repay each loan. “This can lead to a debt spiral if the loan is continually renewed rather than repaid when due,” says Greg McBride, principal analyst at Bankrate.com.
Here are five things to consider before turning to payday loans:
Do you really need it? More than 80% of borrowers told Pew researchers that if payday loans weren’t available, they would cut spending. “Many would also delay paying certain bills, rely on friends and family, or sell personal possessions,” the report said.
It will take you longer to pay it back than you think. The Pew study found and Advance America statistics confirm that borrowers take out an average of eight loans per year. That means you’ll be wading through five months of costly debt.
There are other options. Choices include banks and credit unions. It might be cheaper to get a cash advance on your credit card at an annualized interest rate of 29.99%.
It could ruin your credit score. Although payday lenders don’t report what you borrow to credit reporting agencies, they do report what you don’t repay in full. It is recorded as an uncollected receivable.
Payday lenders rely on your bad financial habits. “The profitability of payday lenders depends on repeat borrowing,” according to a report from the Federal Reserve Bank of Kansas City.