Let’s put it this way: they’re one of those financial arrangements that’s incredibly easy to get into, but painfully difficult to get out of.
In this article, I’m unpacking what payday loans are, and why you should look for alternatives to this type of loan.
What is a payday loan?
A payday loan is a very short-term loan. That’s short-term, as in no more than a few weeks. They’re usually available through payday lenders operating out of storefronts, but some are now also operating online.
Payday loans work best for people who need cash in a hurry. That’s because the entire application process can be completed in a matter of minutes. Literally!
Payday lenders will verify your income and a bank checking account. They verify the income to determine your ability to repay. But the bank account has a more specific purpose.
How do payday loans work?
When your loan is approved, the funds are deposited into the verified bank account. But even more important, the lender will require that you write a postdated check in payment of both the loan amount and the interest charged on it.
For example, let’s say that you’re granted a $500 loan on October 16. Since the loan will require repayment within two weeks, you will write a check back to the lender that’s dated for October 30. The check will be for $575 – $500 for their loan repayment, plus $75 for interest.
The postdated check ensures that the lender will be paid back by the scheduled date and that they won’t have to chase you to get it. Borrowers tolerate the postdated check arrangement because the other major component that lenders normally look at – credit history – is ignored by payday lenders.
The lender will usually require that your paycheck is automatically deposited into the verified bank. The postdated check will then be set to coincide with the payroll deposit, ensuring that the post-dated check will clear the account.
That’s why they’re called payday loans.
The reasons people take payday loans
People with poor credit are natural clientele for payday loans. The borrower can apply for the loan, and not be at all concerned that his credit is either ugly or nonexistent.
People with little or no savings represent another natural market. Most households in America live on a paycheck-to-paycheck basis. A 2019 survey by Go Banking Rates found that 69% of American households have less than $1,000 in savings. That demonstrates the enormous potential market for payday loans, and why they’re so stubbornly popular.
Since bad credit and a lack of savings often go hand-in-hand, payday lenders have a built-in market.
While many people can get by based on regular expenses, an emergency situation creates a need for immediate cash.
For example, if you have bad credit, no savings, and car trouble and you find out that it will take $700 to fix it. You need the car to get to work, and since you have no available credit and no savings, you turn to payday lenders. You may have no idea how to come up with $700 (plus interest) in two weeks, but the loan buys you some time – and you have no idea that there are actually great alternatives to a payday loan.
According to the Pew Charitable Trusts 12 million Americans take out payday loans each year, spending $9 billion on loan fees. And today, federal lawmakers are working to reduce payday loan rates from 400% to 36%.
Payday loans are used in place of emergency savings accounts, although the trust has found that many also use them for regular living expenses.
The bad part about payday loans
The most obvious problem with payday loans is the cost. We just did an example of a borrower who pays $75 in interest for a $500 loan. If that was the cost of interest for a full year, the interest rate would be 15 percent. That would be a decent rate for someone who has either bad credit or no credit, and is taking an unsecured loan.
But the $75 is the interest charged for just two weeks. If you annualize the interest charged for two weeks, it comes to nearly 300 percent. In fact, 300 percent is on the low end. Payday lenders often charge 400 percent, 500 percent, or even much more.
What makes it even more concerning is the fact that it is the interest rate being charged to the people who can least afford it. If a person doesn’t have $500 today, they probably won’t be any more likely to have $575 in two weeks. But that’s what they’ll have to come up with.
And that’s why it gets worse.
The REALLY bad part about payday loans
People who take payday loans often get locked into an ongoing cycle. One payday loan creates the need for a second, which creates the need for a third, and so on.
The problem is that the borrower usually needs to take another payday loan to pay off the first one. The whole reason for taking the first payday loan was that they didn’t have the money for an emergency need. Since regular earnings will be consumed by regular expenses, they won’t be any better off in two weeks.
The lender might provide continuous financing by rolling over the loan every two weeks. The borrower will have to pay the interest every two weeks, but the original loan balance will remain outstanding.
Because the borrower will have to pay $75 every two weeks, he’ll end up paying $1,950 in interest in order to gain the one-time benefit of the $500 loan.
This is another reason why payday loans rarely exceed $1,000. The payday lenders are keenly aware that the likelihood of being repaid declines with the size of the loan.
And should you be unable to make good on your payday loan, lenders are among the most savage when it comes to collecting. You will not only be hounded by collection calls and threats, but you almost certainly will be slapped with a court judgment.
I want to recommend three good alternatives for trying to steer clear from payday loans since payday loans trap you into a cycle that’s almost impossible to get out of.
One of the easiest options is getting an advance on your paycheck with Earnin. Once you sign up with Earnin, they give you access to the paycheck you’ve earned and do not charge you interest or fees whatsoever. By connecting your bank account and employment information to the app, you have control of and access to your hard-earned money without having to pay a penny of interest and fees.
Earnin is community-supported, helping to create fairness across individuals’ finances – so you pay only what you can – even if that’s nothing at all. The idea with Earnin is that community members pay it forward to help support one another.
How to avoid needing a payday loan in the first place
The two most basic reasons why people fall into the payday loan trap are bad credit and a lack of savings. It’s not easy to overcome either problem, let alone both. But since payday loans trap you into a cycle that’s almost impossible to get out of, it’s worth making the effort.
Overcome bad credit
Obviously, you’ll need to make all of your debt payments on time from now on. You should also avoid incurring any new debt, since it will be difficult to repay.
But there is another exception to that rule, and that’s a credit builder loan. Let me explain: these are loans that are designed specifically for people with either no credit or bad credit. They’re offered by some banks and credit unions and are well worth having.
A credit builder loan works by giving you a loan in which the proceeds are deposited into a savings account. The monthly payments are automatically drafted out of the savings account by the lender to pay the loan. Loans are for small amounts, have reasonable interest rates, with terms of anywhere from 12 to 24 months.
Let’s say that you take a credit builder loan for $500. The loan will be for 12 months at 10 percent interest. The loan proceeds will immediately be deposited into a dedicated savings account in your name (you will not have access to the funds in the account). Each month the bank will withdraw an amount sufficient to cover the principal and interest.
The bank will then report your good payment history to the credit bureaus. The idea is that building good credit will help to offset a history of bad credit. This will increase your credit score more quickly than simply paying off bad debt.
Best of all, you won’t have to be concerned with making the monthly payments. And as far as cost, you will only have to deposit enough money into the bank account to cover the interest for one year. At 10 percent interest, that will be something less than $50 for the year.
Overcome a lack of savings
The only way to eliminate the need for payday loans is to become self-funding. And the only way to do that is by having cash in the bank. You’ll be able to use savings when an emergency hits, rather than turning to high-priced lenders.
But how do you build up savings if you’ve never had much in the past?
It will require sacrifice on your part and a commitment that the alternative to a payday loan is to be super disciplined about every penny you earn. My guess is that your budget is already tightly stretched, and therefore the only way to do it will be to increase income. You may have to take a second job or pick up some side hustles for as long as it takes to get enough money into your savings account to give you some budgetary breathing room.
You can also fast-forward the savings process by banking windfalls. Banking your income tax refund is an excellent strategy. But you could also consider selling off anything that you have but don’t need. For example, having a couple of garage sales or selling some stuff on Craigslist could easily raise a few hundred dollars.
You’ll also find that you’re going to have to continue refilling your savings account to prepare for future emergencies. But by then you’ll be in the savings habit, and it will be second nature.
It won’t be easy, but it’s the only way to avoid the dangerous and costly payday loan cycle.
Payday loans are designed to trap you in a cycle of debt. When an emergency hits and you have poor credit and no savings, it may seem like you have no other choice. But choosing a payday loan negatively affects your credit, any savings you could have had, and may even cause you to land you in court.
There are alternatives to payday loans – and good ones. If you need a payday loan, choose one of these other options because getting a loan for 300-500% interest over a few weeks is just never ever the way to go.
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