Part I: What is the industry and how does it work?
According to a survey by Bankrate, roughly 25 percent of Americans live paycheck to paycheck. The money they make just barely covers their day-to-day expenses, with little or nothing left over for emergencies. If you’re in this situation, any unplanned expense – such as a $300 car repair – can cause a financial crisis.
Payday loans – also called “cash advance loans” – appear to offer a way out. You can walk into one of the thousands of payday lending offices across the country and walk out half an hour later with $300 in your hand to pay that repair bill. Then, on your next payday, you can come back in to repay that $300 – plus another $45 or so in interest. \
The problem is, if you had a hard time raising $300 in the first place, losing $345 out of one paycheck leaves a big hole in the budget. And so before the month is out, you could find yourself coming back for another loan to cover the bills you can no longer afford to pay. Before long, you end up entrapped in an ongoing cycle of debt, going from loan to loan, while the interest payments pile up higher and higher. A 2012 report from the Pew Charitable Trusts found that the typical payday borrower takes out eight $375 loans per year, paying a total of $520 in interest.
Many borrowers can’t break free of this cycle without taking extreme measures. They slash their budgets, borrow from friends and family, pawn their belongings, or take out a different type of loan. These are all steps they could have taken to avoid getting the payday loan in the first place, saving themselves all that interest.
So if you want to avoid the payday loan trap, you should make sure you’ve looked at all their other options first. Even when you absolutely need some extra cash to make it through the month, there’s almost always a better way of getting it than turning to a payday loan shark.
The payday lending industry
Payday lending is a big business. The Community Financial Services Association of America (CFSA) boasts more than 20,000 member locations – more than either Starbucks or McDonald’s. About 19 million American households (nearly one out of every six in the country) have taken out a payday loan at some point.
How payday loans work
Payday loans get their name because they usually come due on the borrower’s next payday. They’re different from regular bank loans in several ways: •Smaller amounts. In most states where payday loans are legal, there’s a limit on how much you can borrow this way. This cap ranges from $300 to $1,000, with $500 being the most common amount. The Pew report says the average size of a payday loan is $375.
• Shorter terms. A payday loan is supposed to be paid back when you get your next paycheck. In most cases, this means the loan term is two weeks, though it can sometimes be as long as a month
. • No installments. With a normal bank loan, you pay back the money bit by bit, in installments. For instance, if you borrow $1,000 for one year at 5 percent, you pay back $85.61 each month – $2.28 for the interest and the rest for the principal. But with a payday loan, you have to pay back the whole sum – interest and principal – all at once. For a borrower on a tight budget, this is often impossible.
• High interest. When you borrow money from a bank, the interest you pay depends on your credit rating and the type of loan you’re getting. A borrower with excellent credit can get a mortgage loan with an annual percentage rate (APR) of 3 percent or less. By contrast, someone with bad credit taking out an unsecured personal loan would pay 25 percent or more. But payday loans charge all borrowers the same rate – usually around $15 per $100 borrowed. So, for instance, if you borrow $500, you pay $75 in interest. That doesn’t sound so bad until you remember that the loan term is only two weeks. On a yearly basis, it works out to an APR of 391 percent.
• No credit check. Banks check your credit before giving you a loan to figure out how much to charge you. If your credit is really poor, you probably can’t get a loan at all. But you don’t need good credit – or any credit – to get a payday loan. All you need is a bank account, proof of income (such as a pay stub), and an ID that shows you’re at least 18 years old. You can walk out with your money in less than an hour – a major reason these loans appeal to financially desperate people.
• Automatic repayment. When you take out a payday loan, you hand over a signed check or other document that gives the lender permission to take money out of your bank account. If you don’t show up to repay your loan as scheduled, the lender either cashes the check or withdraws the money from your account.
• Easy renewals. If you know you can’t afford to pay off your loan on time, you can come in before it comes due and renew it. You pay a fee equal to the interest you owe and give yourself another two weeks to pay back your loan – with another interest payment. Or, in states where that’s not allowed, you can immediately take out a second loan to cover what you owe on the first one. That’s how so many users end up taking months to pay what started out as a twoweek loan.
Next Week Part II: Who uses payday loans and their dangers