The Truth About Payday Loans

The Kansas City Star recently reported that a single mother used a payday loan to borrow $300 for a trip to the dentist. When she couldn’t pay the loan two weeks later, she extended it and paid $50 twice a month for almost four months and still owed the entire principle amount.

A woman in North Carolina started with a payday loan of “$50 or $100,” and before she knew it, she was getting one loan to pay another and had racked up $700 in high-interest debt.

These are only two examples of the many people who get sucked into the irresistible rollover gimmick of pay day loans. Friendly store managers reportedly call customers to tell them how easy it is to defer repaying the loan on time by simple writing another postdated check.

What they don’t explain is the concept of compounding interest. And, as I’ve mentioned before, those who understand compound interest are destined to collect it. Those who don’t are doomed to pay it.

Payday loans are short-term cash loans. Borrowers typically write a personal check for the amount borrowed plus the finance charge and receive cash or sign over electronic access to their bank accounts to receive and repay payday loans. On the next payday the loan and finance charge must be paid in one lump sum.

Payday loans can range in size from $100 to $1,000, depending on state legal maximums. The average loan term is about two-weeks and loans cost on average 470% annual interest (APR). Finance charges normally range from $15 to $30 to borrow $100. For two-week loans, these finance charges result in interest rates from 390% to 780% APR. Shorter term loans can have even higher APRs.

Borrowers who obtain payday loans generally have cash flow difficulties, and feel that they have few, if any, lower-cost borrowing alternatives. All they need to get a payday loan is an open bank account in relatively good standing, a steady source of income, and some identification. Lenders do not conduct a full credit check or ask questions to determine if a borrower can afford to repay the loan.

At the end of 2006, The Center for Responsible Lending reported about 25,000 payday loan outlets in the United States and annual loan volume of at least $28 billion, with almost $5 billion in loan fees being paid by consumers.

As the examples have shown, payday loans trap consumers in repeat borrowing cycles due to the extreme high cost to borrow, the very short repayment term, and the consequences of failing to make good on the loan amount. Consumers who use payday loans have an average of eight to thirteen loans per year at a single lender.

Under the Truth in Lending Act, the cost of payday loans must be disclosed to the consumer. Among other information, you must receive, in writing, the finance charge (a dollar amount) and the annual percentage rate or APR (the cost of credit on a yearly basis). However, in a Consumer Federation of America (CFA) survey of 100 Internet payday loan sites, only 38 sites disclosed the annual interest rates for loans prior to customers completing the application process, and only 57 sites quoted the finance charge.

Internet payday lending adds security and fraud risks to payday loans. The CFA warns consumers to exercise extreme caution when using Internet payday loan sites. According to the CFA, small loans involving electronic access to consumers’ checking accounts pose high risks to consumers who borrow money by transmitting personal financial information via the Internet.

Contracts from Internet payday lenders often include a range of one-sided terms, such as mandatory arbitration clauses, agreements not to participate in class action lawsuits, and agreements not to file for bankruptcy. Some lenders require applicants to agree to keep their bank accounts open until loans are repaid.

If you need credit, a payday loan is probably the last place you want to look. Consider other options first such as a small loan from your credit union or small loan company, an advance on pay from your employer, or a loan from family or friends. A cash advance on a credit card may also be a possibility, but you’ll want to understand the terms before going that route.

If you ignore everything I have just said, and still feel that you must use a payday loan, please, for the love, borrow only as much as you can afford to completely pay off with your next paycheck while still having enough left to make it to the next payday.