How Payday Loans Work — And Why You Should Avoid Them

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You’ve probably heard that payday loans are bad news. There are plenty of reasons for the stigma surrounding this product. Filling in financial gaps with payday loans can lead to a vicious debt cycle.

According to a report released by Pew, the average borrower who takes out a payday loan is in debt for five months and spends an average $520 in fees while repeatedly borrowing $375. Similarly, the Consumer Financial Protection Bureau found that over 80% of payday loans roll over or borrowers take out another payday loan within 14 days.

In this post, we’ll discuss what exactly a payday loan is, why it’s dangerous and alternatives to consider when money is tight.

What is a payday loan?

A payday loan is a short-term loan of a small amount, typically $1,000 or less, that you’re meant to pay back the next time you receive a paycheck. Payday loans can also be called cash advance loans or check loans. If you can’t pay the loan by your next payday, the lender may allow you to roll over the loan into a new term for an additional fee. You can often find payday loans at check cashing places in strip malls.

Payday loans are typically used by low-income borrowers who need access to quick cash to pay everyday bills. A Pew survey found that payday loan borrowers typically earn less than $40,000 per year.

The fees and interest are where the red flags appear: “I’ve seen [interest rates] upwards of 700%,” said Natalie Fountain, a financial wellness expert at GreenPath, Inc., a financial wellness nonprofit.

The cost of a payday loan isn’t always expressed as a percentage. Instead, it may be called a “finance charge,” but when calculated as an APR, it can be astronomical. The average fee, according to Pew, is $55 per loan from a storefront lender and $95 on average for a payday loan offered online.

Fees can vary from lender to lender. Fountain, based in Farmington Hills, Mich., has seen instances where borrowers have to pay a fee per dollar amount. For example, the borrower pays $15 to $40 per $100.

Let’s say you borrow $500, there’s a $20 fee per $100 and you renew at the end of the two-week period for another $50 fee. The loan would cost you $150 in one month. Imagine you kept renewing. After just five months, the total fees would surpass the original $500 loan.

Fees should be stated in the contract you sign. Read all documents with an eagle’s eye. Some states set a maximum fee for payday loans. Other states prohibit payday loans entirely.

Why payday loans are dangerous

Payday loans are often advertised as products to help you cover unexpected bills. However, a majority of borrowers use them for everyday expenses to solve an income gap.

“Most of what I see is people rolling over or renewing the loan. That’s when people get caught in the cycle of the loan and never get out of it,” said Fountain. Over the years, she has found that some people are able to pay it back in two weeks or maybe a month, but many become trapped in debt.

The real danger of payday loans is getting into the pattern of only paying the renewal fees when the loan is due because that fee is all you can afford. The fees may not seem problematic for a short term when you’re in a pinch. But repeatedly borrowing can turn it into a long-term situation that digs you into a deep hole.

Payday loans are easy to get

Payday loans don’t have many requirements, which is what makes them so easy to access. “You can get [payday loans] almost immediately. There’s really no wait, and almost everyone can get one,” Fountain said. A credit check may not be required. In fact, Fountain has worked with borrowers who have payday loans that don’t show up on their credit reports at all. Payday lenders may not report accounts to bureaus.

The one requirement payday lenders do typically have is that you write a post-dated check for the balance or give them direct access to your bank account for the payment. Giving a lender authorization to make bank withdrawals is another area that can cause problems.

A withdrawal can trigger an overdraft if you don’t have enough money when the payment is due. On top of struggling to repay a loan, you could have overdraft fees and a negative account balance to rectify with your bank.

How to resolve your payday loan woes

We’ve driven the point home about the dangers of payday loans. What if you already have payday loans that you’re trying to recover from? There are solutions.

Fountain recommends slowly backing down on the loan. If you have a loan that you keep renewing, try to borrow less each time you renew. For example, if you have a $1,000 payday loan that you keep paying just a renewal fee on, borrow $800 on your next go around and so on until the debt is paid off.

Another option is signing up for a debt management program with a credit counseling organization. Counselors can possibly negotiate better terms like a monthly payment as opposed to one lump sum that’s challenging to pay off.

If you’re buried under multiple debts, you may also consider debt consolidation. That’s where you get a new loan to pay off your existing debts. The new loan should have a lower interest rate and better terms to make repayment easier — or at least lower your overall debt costs. You can see offers from up to five different lenders by using this personal loan tool from LendingTree.

Learn more about how to dig your way out of payday loan debt here.

5 better alternatives to payday loans

Below are some alternatives to review before you settle with a payday loan:

1. Consider peer-to-peer (P2P) lending

Don’t shy away from long-term loans. Short-term loans may seem better because it’s marketed as a shorter commitment. But when you take into account factors like high interest, high fees and unmanageable lump-sum payment requirements, a long-term loan is likely a better solution.

Peer-to-peer loan products can have flexible qualifying criteria for those with less-than-stellar credit. LendingClub and Peerform are examples of P2P online marketplaces where you can get a loan funded by peer investors if you have a credit score of at least 600.

Interest rates for these products currently range from 5.99% to 35.89% APR. You can shop for P2P loans online with a soft inquiry. It’s possible to apply and get funding within a few business days. A P2P loan works like a traditional installment loan where you pay a set amount monthly for a term that can be 36 to 60 months. Shop for P2P loans and other personal loans here.

2. Try a credit card

Credit cards get a bad rap because excessive use of them can also land you in a debt trap. But when used responsibly, credit cards can be a more affordable way to borrow money than payday loans. The average credit card interest rate is currently 14.38% compared with the triple-digit interest rates that you can find with a payday loan.

Credit cards may offer a cash advance option as well, although cash advances may have a higher APR and can come with a cash advance fee of 3% or 5%. However, there are some credit cards that don’t have a cash advance fee.

The application for credit cards is fairly quick. You can apply online and get an instant response. It can take a few weeks for the physical card to come in the mail to activate the account. Compare credit card offers here.

3. Work with your local bank or credit union

Sometimes a local bank or credit union may be willing to lend you a small amount if you’re a loyal customer or member. Speak with your financial institution to see if there are affordable products available.

One product to ask your credit union for is the payday alternative loan or PAL. PALs are small loans that may be offered as a solution for members when money is tight. PALs are typically $200 to $1,000 and can have loan terms of one to six months. These products may come with administrative fees of up to $20.

4. Borrow from friends and family

If you need quick cash and you can’t wait for a loan or credit card, asking friends and family for a favor can get you out of a tough spot. Set up a repayment agreement to avoid awkward conversations about when you’ll pay the money back.

5. Work out bill arrangements and lower your expenses

Jump on the phone before bills get out of control. Try to contact companies you owe money instead of leaning on payday loans to bridge the gap between paychecks. You could ask for bill extensions or a payment plan.

Another proactive step is to lower your monthly bills where you can. Cut the cord on cable. Negotiate a lower rate for your telephone bill and other services. Take on a roommate. Start a side hustle. Reducing expenses and increasing your income can help you avoid short-term loan products for everyday living expenses.

Shop around before making a decision

When bills are due, it’s understandable that you look for the quickest way to solve the problem. Take a deep breath and consider alternatives before going to your local check advance storefront for money. Weighing your options can help you avoid taking a course of action that can put you in even more financial trouble.

This article contains links to LendingTree, our parent company.

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