According to a survey by Bankrate, roughly 25% 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%, 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% or less. By contrast, someone with bad credit taking out an unsecured personal loan would pay 25% 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%.
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 two-week loan.
Who Uses Payday Loans and Why
According to the 2012 Pew report, 12 million Americans take out payday loans each year. About 5.5% of all American adults have used one within the past five years.
The people most likely to use payday loans are:
Young(ish). More than half of all payday loan users are between 25 and 44 years old. About 9% of people in their 20s, and 7% to 8% of people in their 30s, have used this type of loan in the last five years. By contrast, people over 60 years old are unlikely to use payday loans. About 24% of all Americans are 60 or older, but only 11% of payday borrowers are.
African-American. Most payday borrowers are white, but that’s because white people are such a large group. African-Americans, who make up only 12% of the population, take out nearly a quarter of all payday loans. Roughly 1 in 8 African-American adults have used a payday loan in the past five years, compared to only 1 in 25 white adults.
Low-Income. The median household income in the country was $53,657 in 2014, according to the Census Bureau. However, most payday loan users have income well below this level. More than 70% have a household income of less than $40,000. People in this group are three times as likely to use payday loans as people with incomes of $50,000 or more.
Renters. People who rent are much more likely to use payday loans than people who own their homes. About 35% of American adults are renters, but 58% of payday borrowers are. About 1 out of 10 renters has used a payday loan in the past year.
Relatively Uneducated. More than half of all payday loan users have no education beyond high school. Less than 15% of them have a four-year college degree.
Unemployed or Disabled. Payday lenders are perfectly happy to borrow against your unemployment or disability benefits. About 1 in 10 unemployed Americans has used a payday loan in the past five years – although they may have been employed when they took out the loan. Disabled people use payday loans at an even higher rate. Roughly 12% have used one in the last five years.
Separated or Divorced. Only about 13% of American adults are separated or divorced. However, this group makes up 25% of all payday loan users. About 13% of separated and divorced adults have taken out a payday loan in the last five years.
Payday lenders often market their products as short-term fixes for emergency needs, such as car repairs or medical bills. But according to the Pew survey, most users don’t use them that way. Nearly 70% of first-time borrowers say they took out their loans to help pay for basic needs, such as rent, food, utilities, or credit card bills. Only 16% say they borrowed the money for an unplanned, one-time expense.
When Pew asked people what they would do if they couldn’t use payday loans, they gave a variety of answers. More than 80% said they would cut back on basic expenses, such as food and clothing. More than half also said they would pawn something or borrow from friends and family. However, most users did not say they would use credit cards or take out bank loans – possibly because many don’t have good enough credit to qualify.
Dangers of Payday Loans
The most obvious problem with payday loans is their extremely high interest rates. The fee for a payday loan can be anywhere from $10 to $30 per $100 borrowed, which works out to an annual interest rate of 261% to 782%. But these loans also have other dangers that are less obvious.
These dangers include:
Renewal Fees. When borrowers can’t pay back a payday loan on time, they either renew the loan or take out a new one. So even though they keep making payments on their loans, the amount they owe never gets any smaller. A borrower who starts out with a $400 loan and a $60 interest payment and then keeps renewing the loan every two weeks for four months will end up paying about $480 in interest – and will still owe the original $400.
Collections. In theory, a payday lender should never have any problem collecting a debt, because it can take the money right out of your checking account. The problem is, if that account is empty, the lender gets nothing – and you get socked with a hefty bank fee. But the lender usually won’t stop with one attempt. It keeps trying to collect the money, often breaking up the payment into smaller amounts that are more likely to go through. And, at the same time, the lender starts harassing you with calls and letters from lawyers. If none of that works, the lender will probably sell your debt to a collections agency for pennies on the dollar. This agency, in addition to calling and writing, can sue you for the debt. If it wins, the court can allow the agency to seize your assets or garnish your wages.
Credit Impacts. Payday lenders generally don’t check your credit before issuing you a loan. For such small loans at such short terms, it’s just too expensive to run a credit check on each one. However, if you fail to pay back your loan, the credit bureaus can still find out about it. Even if the payday lender doesn’t report it, the collections agency that buys it often will, damaging your credit score. Yet if you do pay back the loan on time, that payment probably won’t be reported to the credit bureaus, so your credit score won’t improve.
The Cycle of Debt. The biggest problem with payday loans is that you can’t pay them off gradually, like a mortgage or a car loan. You have to come up with the whole sum, interest and principal, in just two weeks. For most borrowers, a lump sum this size is more than their budget can possibly handle – so they just renew their loans or take out new ones. According to the Consumer Finance Protection Bureau, roughly four out of five payday loans end up being renewed or rolled over to a new loan.
Laws About Payday Lending
The laws about payday lending vary from state to state. States fall into three basic groups:
Permissive States. In 28 states, there are very few restrictions on payday lending. Lenders can charge $15 or more for each $100 borrowed, and they can demand payment in full on the borrower’s next payday. However, even these states have some limits. Most of them put a limit on how much money users can borrow – either a dollar amount or a percentage of the borrower’s monthly income. Also, a federal law bars lenders in all states from charging more than a 36% annual percentage rate (APR) to active-duty members of the military. Many payday lenders deal with this law by refusing to make loans to service members.
Restrictive States. In 15 states, plus Washington, D.C., there are no payday loan offices at all. Some of these states have banned payday lending outright. Others have put a cap on interest rates – usually around 36% APR – that makes payday lending unprofitable, so all the payday loan offices have closed. However, borrowers in these states can still get loans from online payday lenders.
Hybrid States. The remaining eight states have a medium level of regulation. Some cap the interest payday lenders can charge at a lower rate – usually around $10 for each $100 borrowed. This works out to more than 260% annual interest based on a two-week term, which is enough for payday lenders to make a profit. Others limit the number of loans each borrower can make in a year. And finally, some states require longer terms for loans than two weeks. For example, Colorado passed a law in 2010 requiring all loans to have a term of at least six months. As a result, most payday lenders in the state now allow borrowers to pay back loans in installments, rather than as a lump sum.
The Pew report shows that in states with stricter laws, fewer people take out payday loans. That’s partly because stricter laws usually mean fewer payday loan stores, so people can’t just go to the nearest store for fast cash. People in restrictive states still have access to online lenders, but they’re no more likely to use them than people in permissive states.
In June 2016, the Consumer Finance Protection Bureau proposed a new rule to regulate payday lending at the national level. This rule would require lenders to check borrowers’ income, expenses, and other debts to make sure they can afford to pay back the loan. It would also limit the number of loans a borrower can take out consecutively, helping to break the cycle of debt. And finally, it would require lenders to let borrowers know before pulling money out of their bank accounts and limit the number of times they can try to withdraw money before giving up.
This rule hasn’t taken effect yet, and many payday lenders are hoping it never will. The CFSA released a statement claiming this rule would force payday lenders out of business. This, in turn, would “cut off access to credit for millions of Americans.”
However, Pew argues that there are ways to change the rules that make it easier for low-income Americans to get the credit they need. The problem is, the proposed rule doesn’t do that. Instead, Pew says, it would let payday lenders keep charging triple-digit interest rates while making it harder for banks to offer better, cheaper alternatives. Pew has proposed its own rule that would restrict short-term loans, but would encourage longer-term loans that are easier to repay.
Auto Title Loans
To get around the restrictions on payday lending, some lenders offer auto title loans instead. However, this so-called alternative – which is illegal in about half the states in the country – is really just a payday loan in disguise.
When you take out an auto title loan, the lender examines your car and offers you a loan based on its value. Typically, you can get up to 40% of the car’s value in cash, with $1,000 being the average amount. Then you hand over the title to the car as collateral for the loan.
Car title loans have the same short terms and high interest as payday loans. Some are due in a lump sum after 30 days, while others get paid in installments over three to six months. Along with interest of 259% or more, these loans also include fees of up to 25%, which are due with your last payment.
If you can’t make this payment, you can renew the loan, just like a payday loan. In fact, the vast majority of these loans are renewals. Pew reports that a typical title loan is renewed eight times before the borrower can pay it off. So just like payday loans, auto title loans trap their users in a cycle of debt.
However, if you can’t afford to pay the loan or renew it, the lender seizes your car. Many lenders make you turn over a key or install a GPS tracker to make it easier for them to get their hands on the vehicle. Some of them even store the car while they’re waiting to sell it – and charge you a fee for the storage. And if the amount they get when they sell the car is more than what you owe them, they don’t always have to pay you the difference.
Alternatives to Payday Loans
It’s easy to argue that payday loans and auto title loans are just plain evil and should be banned completely. But the problem is, there’s a demand for them. A Pew survey finds that most payday loan users say these loans take advantage of them – but at the same time, most say the loans provide much-needed relief.
Fortunately, there are better ways to raise cash in a crisis. Sometimes, it’s possible to get by without borrowing money at all. You can sell off belongings or ask for an advance on your paycheck. You can also apply for emergency aid, such as Medicaid or SNAP (food stamps), or seek help with paying off other debts.
But even if you need to borrow money, there are better places to turn than a payday loan office. In many cases, friends and family can help you out with a loan. Pawn shops and many online lenders offer small loans, even to people with bad credit.
Finally, if you have a credit card, a retirement fund, a life insurance policy, or even a bank account, you can tap into it as a source of emergency cash. These options are costly, but in the long run, they’re better than being trapped in payday loan debt.