When you’re in a financial pinch and need money fast, you may be tempted to take whatever opportunity you can find. Unfortunately, fast funding options like payday loans often do more harm than good.
While they allow you to get your hands on fast cash, their high interest rates and hidden fees can raise your borrowing costs significantly and keep you trapped in a payday loan cycle.
Before taking out a payday loan, make sure you understand the downsides, as well as what alternatives might be available to you. In most cases, there’s likely a better option.
A payday loan is a short-term, high-interest loan. While loan amounts vary, they are often around $500 or less. And, as the name suggests, the loan is designed to be repaid on your next payday, usually within two to four weeks.
Payday loans generally don’t have the same eligibility requirements as regular personal loans. The lender may not take into account your credit score or whether you actually have a debt-to-income ratio (DTI) that allows you to repay the loan.
When you take out the payday loan, you often must provide either a postdated check for the total amount due or authorization to take the money out of your bank account on the due date, which assures the lender they’ll get their money back.
Payday loans generally have high interest rates. A typical annual percentage rate (APR) could be around 400%, which is nearly 20 times the interest rates on many credit cards.
Payday loans are meant to be repaid in a single lump sum, but given the target market of these loans, that’s not always possible. Instead, you may have the option to renew or roll over the loan. You’ll have more time to repay the loan, but will end up owing considerably more.
Payday loan fees can range from $10 to $30 per $100. Suppose you borrowed $500 on a two-week payday loan with a fee of $20 per $100, for a total fee amount of $100. While $100 may not sound like all that much, it’s likely a lot of money for someone resorting to a payday loan. And when you run the numbers, the APR turns out to be more than 520%.
Compare that with a personal loan you would get from a bank, credit union, or online lender. Even personal loans for borrowers with poor or fair credit tend to have maximum interest rates of around 35%.
Payday loans can be a fast and convenient funding source, but it’s important to understand the downsides before you borrow.
Payday loans, like other types of financial products, are regulated in the United States. The Federal Trade Commission (FTC), Consumer Financial Protection Bureau (CFPB), and individual states have taken actions to make payday loans less predatory.
First, the FTC enforces rules that prohibit payday lenders from engaging in deceptive or unfair marketing and billing practices, abusive debt collection practices, and more.
Next, the CFPB has enacted a rule that prohibits payday lenders from attempting to withdraw payments directly from a borrower’s account if two consecutive payments have failed and the interest rate on the loan exceeds 36% APR.
Finally, many states have passed laws limiting payday loan amounts, loan terms, and finance charges. For example, in Alabama, payday loans can’t exceed $500, the repayment term can’t be less than 10 days or more than 31 days, and the finance charge can’t exceed 17.5% of the loan amount.
Other states have even stricter regulations. For example, Colorado requires that payday loan repayment terms be at least six months long and that APRs not exceed 36%. Additionally, the state requires that borrowers be able to repay their loans early and recoup the prorated amount of interest for the remaining loan term.
The National Conference of State Legislatures has compiled a database with all state laws concerning payday loans so you can see what laws apply in your state.
Here are several alternatives that can be better options:
Yes, payday loans often don’t have a minimum credit score requirement the way that personal loans do. As a result, you can qualify even if you have bad credit.
Payday loans have notoriously high interest rates, often reaching or exceeding 400% APR. That, combined with their short repayment terms, often leads to a cycle of debt where people must continue to take out new payday loans to pay off their existing ones.
If you can’t repay your payday loan by the due date, you may have the option to renew it or roll it over. While this option can be beneficial and buy you extra time to come up with the money, it will also result in you paying far more in interest or fees.
No, payday lenders generally don’t report to the credit bureaus, meaning these loans don’t help build your credit. However, if you don’t pay back the loan, it may be sold to a debt collector and reported to the credit bureaus, which would likely decrease your credit score.