New research confirms what we already knew: If you're down on your luck and can't pay the bills, paying 400 percent interest isn't going to help.
Payday loans, no matter how reasonable they might look on the surface, are nothing less than a financial kick in the stomach, often delivered to those least able to afford it.
A February 2013 report by the Pew Charitable Trusts says almost 12 million Americans take out payday loans every year. And as you might imagine, the borrowers are frequently those least able to afford it. According to Pew, the typical borrower is white, female, 25 to 44 years old, without a college degree, and making less than $40,000 a year.
The report shows that a majority of those surveyed – 58 percent – had trouble meeting monthly expenses at least half the time and turned to payday loans as a financial option to handle the shortfall.
How payday loans work
Payday loans are small, short-term loans backed by your paycheck. You apply for a loan, listing your next two or three pay dates on the application. After getting approved, you write a postdated check for the loan amount plus interest and fees. On your next payday, the lender collects the balance, unless you choose to roll the loan over until your next payday.
Most payday lenders don’t consider your credit history, so people with bad credit can still get approved as long as they have a source of income. And many lenders will give you the cash in just a few days, or hours in some cases.
Why they suck
Payday loans come with steep fees and interest rates – upwards of 300 percent.
Take a look at Credit.com’s list of payday loan laws by state showing the maximum interest rate lenders can charge. Check out some of these terms:
Alabama – 17.5 percent
Colorado – 20 percent of the first $300, 7.5 percent for the remainder
Louisiana – 16.75 percent
These interest rates may not appear excessive – they seem similar to credit card rates. But credit cards quote the amount you’ll pay over a year, while payday lenders collect their interest in as little as a week. Annualize rates like those above and you’re paying triple-digit interest. Florida law, for example, allows only 10 percent interest, plus a $5 fee for loans from seven to 31 days. Do that for a year and you could be paying nearly 400 percent.
It’s when the loan gets extended – called a rollover – that the fees really add up. Lenders allow customers to extend their loans to the next payday if they pay the fee plus any accrued interest. The borrowers become trapped in a loop of paying fees and interest because they aren’t paying down the principal. And according to the Pew report, fewer than 2 out of 10 borrowers can afford to pay off the average loan when it comes due.
Average borrowers end up taking five months to pay off a loan, the report says, paying $520 in finance charges for loans averaging $375.
Why do we allow this?
While the industry claims “short-term credit products are an important financial tool for individuals who need funds to pay for an unexpected expense,” there’s evidence people can survive without them. From the Pew report:
In states that enact strong legal protections, the result is a large net decrease in payday loan usage…In states with no stores, just 5 out of every 100 would-be borrowers choose to obtain payday loans online or from alternative sources, while 95 choose not to use them.
There’s been an effort in some states for years to regulate payday loans. In our 2010 article Payday Lenders Dropping Like Flies, we reported payday lender Advance America closed all 47 of their locations in Arizona after a law passed limiting interest to an annualized 36 percent.
What’s the alternative?
The irony revealed by the Pew report is some borrowers end up turning to family and friends to repay their loans – something they could have done first and avoided the payday loan in the first place.
The Center for Responsible Lending offers other alternatives, including working out a payment plan with creditors, asking for an advance at work,
- community-based emergency assistance programs, loans from
- credit unions,
- cash advances from credit cards, and
- small consumer finance companies, where rates are often lower.
The long-term solution is not living paycheck to paycheck – obviously something tough for the working poor to do.
Using a financial windfall like a pay raise or a tax refund is a good way to start getting yourself out of the trap. And there are plenty of little ideas that could add up; see articles like 30 Tips to Spend Less and Save More.
Some of my favorite ways to trim spending include:
1. Start with the little things. Whether it’s beer, cigarettes, the lottery, lattes, or junk food, many people blow $5 a day because they think it doesn’t matter. It does: $5 a day for a month is $150. Over a year, it’s more than $1,800.
2. Brown bag it. It takes planning to bring your lunch to work, but in the long run it’s healthier and much cheaper than fast food. See 7 Cheap and Easy Work Lunches You Can Bring From Home.
3. Buy generic. Many products are the same regardless of the name on the package. Check out 7 Things You Should Always Buy Generic for ideas.
The bottom line
Payday loans may be convenient, but they’re a rip-off. There are only two ways out of the trap: make more or spend less. If you’ve done everything you can to trim your expenses, check out stories like 8 Weird Ways to Make Extra Money.