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What are payday loans?

What are payday loans?
What are payday loans?

Payday loans are small loans that are used in cases of temporary financial emergencies.

Usually, these are short-term loans of a modest amount of money. To get a payday loan, the borrower typically writes a check for the loan amount plus a fee. The check might be left with the lender and he will cash it once the repayment is due.

If the borrower can’t repay when the loan is due, he can sometimes “roll it over” so that the loan is extended. However, the fees keep accumulating. Some states either outlaw rollovers or limit the number of possible renewals.

Payday loans are sometimes offered as “no credit check” loans. The borrower doesn’t need a good credit score and approval is easy compared to other traditional loans. As a result, they are popular among people facing financial difficulty.

Unfortunately, there are very few situations in which payday loans actually end up being helpful. Before you use one, make sure you understand the costs and risks.

Online payday loans warnings

Online payday loans warnings
Online payday loans warnings

When taking out payday loans online, you should keep in mind that the Consumer Federation of America (CFA) has long advised consumers to exercise extreme caution. This is particularly important when using internet payday loan websites, where loans can cost up to $30 per $100 borrowed and the annual interest rates (APRs) are 650%.

According to a CFA survey, small loans that involve electronic access of consumers’ checking accounts pose high risks to consumers who are transmitting personal financial information via the internet. Online payday loans are popularized through email, online search, paid ads, and referrals. Usually, a consumer fills out an online application form with his personal information, bank account numbers, Social Security Numbers and employer information and applies for the online payday loan with copies of a check, a recent bank statement and signed paperwork.

Payday loans and access to customers’ bank accounts

Payday loans could cost up to $30 per $100 borrowed and must be repaid or refinanced by the borrower’s next payday. Let’s say that the borrower’s payday is in two weeks. A $500 loan would cost $150. This means that $650 will be electronically withdrawn from the borrower’s account.

Many lenders automatically renew loans by electronically withdrawing the charges from the borrower’s checking account on payday. If consumers don’t have enough money to cover for the charge or repayment, both the lender and the bank will impose insufficient funds fees.

High cost comes with high risk

High cost comes with high risk
High cost comes with high risk

Online payday loans are dangerous for cash-strapped borrowers as they combine high borrowing costs and collection risks of check-based payday loans with the security risks of sending bank account numbers and Social Security Numbers over web links to unknown lenders.

The CFA’s survey showed that loan amount could range from $200 to $2,500, with $500 the most frequently offered amount. Finance charges range from $10 up to $30 per $100 borrowed on a most frequent rate of $25 per $100, or 650% annual interest rate (APR) if the loan is repaid in a couple weeks.

Not all sites will disclose the annual interest rates for loans or their finance charge before the customers complete the application process. The most frequently posted APR is 652%.

Although loans are due on the borrower’s nearest payday, many sites automatically renew the loan, withdraw the finance charges from the borrower’s bank account and extend the loan for another pay cycle. Some sites permit loan renewals with no reduction in principal.

Some direct lenders require consumers to take additional steps to actually repay the loan. After several renewals, some direct lenders require borrowers to reduce the loan amount with each renewal.

Contracts usually include a range of one-sided terms such as mandatory arbitration clauses, agreements not to participate in class action lawsuits and not to file for bankruptcy. Some lenders require their customers to agree to keep their bank accounts open until loans are fully repaid. Others ask for wage assignments even in states where they are illegal.

Therefore, CFA advises consumers not to borrow money based on giving a post-dated paper check or electronic access to a bank account. Payday loans are too expensive and too hard to repay on a short term. CFA advises consumers never to transmit bank account numbers, Social Security numbers or other personal financial information via the internet or by fax. Consumers should search for lower cost credit, comparing both the finance charge and the APR. CFA also urges consumers to seek credit counseling or legal assistance.

Payday loan pitfalls

High fees & interest rates
High fees & interest rates

The main pitfall with payday loans is their cost. The fees are extremely high and don’t help in solving the financial problem of the borrower. If the borrower is already having financial difficulties, payday loans can only make things worse because of their high-interest rates. As a short-term strategy, payday loans may get the borrower through a rough patch. For example, for an emergency repair for your car so that you can get to work and keep earning income. As a long-term strategy, payday loans will probably only do more harm than good.

Bounced checks that the borrower writes to the payday loan lender can end up in his ChexSystems file and result in overdraft charges from the bank. Banks and retailers may then be unwilling to work with that customer. The lender may also sue him or send his account to collections, which will have a negative impact on his credit.

Also, if constantly stretching out payday loans, the borrower will pay far more in interest and fees than he has ever borrowed in the first place.

Bank payday loans’ disadvantages

Banks are also acting as payday loan lenders, most likely in order to earn more revenue. While qualification for traditional bank loans is based on the customer’s credit, income and assets, they can be a better alternative. Bank payday loans are no better than common payday loans. Actually, they’re still expensive and risky.

In fact, payday loans from banks can be even worse than those from a payday loan store. This is due to the fact that the bank has access to the client’s checking account and he agrees to let them pull funds from it to repay the loan. If they want their money, they’ll take it as soon as it’s available, regardless of whether the client needs money for mortgage or car payments. When the borrower seeks financing elsewhere, he may have more control over how and when his money leaves his bank account.

Nevertheless, it’s possible that the bank can offer better terms.

The problem with rollovers

The core problem with rollovers is the “spiraling” fees. How do they work? If you have a job, a payday lending company will allow you to write a postdated check and will charge a very high interest rate. Suppose you borrow $300 for two weeks from a payday lender for a fee of $45 and decide to rollover the loan instead of repaying – you’re supposed to pay the $45 fee, and then will owe $345 or the principal plus the fee on the second loan. If you pay the loan then, you would have paid $90 in fees for a sequence of two $300 payday loans.

Payday lenders often advertise their two-week loans as the solution to short-term financial emergencies. Indeed, about half of initial loans are repaid within a month. However, about 20% of new payday loans are rolled over six times or three months, so the borrower ends up paying more in fees than the original principal.

Payday loans fill a niche – subprime borrowers who need money before their next paycheck.  Nevertheless, there are some shady practices in the industry which can trap borrowers in a cycle of dependency.

According to some researchers, 20% of borrowers who roll over repeatedly are sometimes being fooled, either by lenders or by themselves, about how quickly they can manage to repay their loan. Behavioral economists have concluded that some people don’t always act in their own best interest – they can make systematic mistakes that jeopardize their own welfare. If chronic rollovers indeed reflect behavioral problems, capping them would benefit borrowers who are prone to such problems.

The CFPB warnings about the payday loan industry

The CFPB warnings about the payday loan industry
The CFPB warnings about the payday loan industry

The CFPB or Consumer Financial Protection Bureau is a new independent agency under the Federal Reserve of the US.

The CFPB can make rules that bind financial institutions and investigate consumer complaints about financial institutions. It can monitor and issue reports on markets and financial products.

The accounts they studied with identifiable payday loans paid an average of $2,164 over the 18 months studied, and $185 in overdraft and non-sufficient fund fees to their banks. Of those fees, $97 on average are charged on payment requests not preceded by a failed payment request. $50 on average are charged because of re-presentment of a payment request after a prior request has failed, and $39 on average are charged because a lender submits multiple payment requests on the same day.

It has become obvious that the number of completely successful borrowers was only half of the population of payday loan borrowers.

The “re-presentment” used by the CFPB, means the following:

Payday loan borrowers are among the lowest rated borrowers and they often do not borrow loans with the intent of repaying them. A lender’s’ strategy, therefore, is to split payments into multiple requests to try to recover at least some of the payment.  For example, a debt of $300 would be split into three requests of $100. After all, it’s better for a lender to receive some repayment than none at all.

However, if the first one fails and the bank charges the borrower an overdraft fee, would the lender keep trying to receive payment for the other two requests? Sometimes there is a grace period, but sometimes there are requests that happen on the same day.

Usually, 5-7 days or 14 days are the most common retry dates, with 2 weeks is the most common successful retry date. Some of the 0 day pings are successful but are causing overdrafts.

The people who take out payday loans are often desperate as they don’t have many other credit options to turn a 2-week paycheck cycle into real liquidity. Payday loans and auto title loans fill an underserved niche. Therefore, eliminating the industry will drive borrowers to pawn shops and illegal lenders and loan sharks.

The CFPB has proposed a framework to regulate payday loans. Google banned all ‘payday loan’ ads, defined as having repayment dates of under 60 days or effective APRs over 36% from the AdSense ecosystem.

Nevertheless, 50% of borrowers are completely successful with payday loans and cleaning up the industry could force them to seek out worse alternatives.

Tips when using payday loans

Tips when using payday loans
Tips when using payday loans

There are three important things to consider when taking out payday loans. First of all, you should be aware why are you going to use one. The average consumer can end up paying up to 400% interest on a two-week loan of approximately $100. Therefore, you should not take out a loan for general living expenses if you don’t wish to find yourself in a cycle of consumer debt.

They can be effective in meeting an unexpected purchase and providing short-term relief to a financial crisis. however, they are entirely unsuitable for helping you to settle monthly bills or living expenses.

Secondly, be certain whether you can afford to repay the interest. The interest rates can fluctuate wildly between different states, starting at approximately 237%, depending on the individual lender and the duration of the contract. It is therefore important to calculate the total amount that would be repayable at the end.

Lastly, never use multiple lenders. This can be an illegal and entirely inappropriate practice. You should only secure a single loan against any given pay check, as it is an offense to have more than one advance on a salary payment and it can also leave you with debts that are greater than your monthly salary.

Alternatives to Payday Loans

Instead of using a payday loan, people in need should consider other alternatives. They can, for example, build up an emergency cash fund in their savings account or build credit in order to borrow from mainstream lenders. They can also keep an open credit card for emergency expenses or get a signature loan from a bank or credit union. Another option is to negotiate a payment plan with their lenders or investigate overdraft protection plans for their checking account. Peer-to-peer lending services are also viable options.

In conclusion

Payday loans are very useful if an emergency or an unexpected event arises, but it is the consumers’ duty to understand their nature and use them responsibly. Paying attention to the terms of the loan and the interest rate is critical as this helps you to decide whether it is suitable for you and if you can afford it. Otherwise, you may run the risk of becoming trapped in a debt cycle.