If you are in need of quick cash, you may be considering a payday loan. Although these types of loans are heavily advertised, think carefully before you get one. Payday loans end up costing enormous amounts of money, and once you go down the payday loan path, you could end up on the payday loan "treadmill." Here's why payday loans are rarely a good option if you need money.
(Learn about other options to avoid if you need quick cash.)
The payday loan industry is growing fast. In some states, these loans are illegal. A payday loan (some banks call them advance loans) works like this: Either you give the lender a check and get back an amount of money less than the face value of the check, or you sign an agreement giving the lender the right to withdraw money either from your bank account or from a prepaid card to which money, like wages, is regularly added.
Example. You give the lender a postdated check for $300, and it gives you $250 in cash and keeps the remaining $50 as its fee.
The lender holds the check for a few weeks (often until your payday). At this time, you must pay the lender the face value of the check ($300), usually by allowing it to cash the check. If you can’t make the check good, the lender requires you to pay another fee ($50 in the above example). At this point, you owe the lender $350 (the $250 borrowed plus the first $50 fee, plus a new fee of $50).
The cost is the same if you give the lender the right to access your bank account or prepaid card instead of a check. The money you borrow (minus the lender’s fee) is deposited directly to your account or card and the payday lender withdraws the payment when due.
If you need another loan that week, the lender charges an additional fee, and so on. Many people who can’t make the original check good get into a “treadmill of debt” because they must keep writing new checks or allow additional withdrawals from their account to cover the fees that have accumulated, in addition to paying off the amount borrowed.
According to the Pew Center on the States, borrowers using payday lenders average eight loans per year. This means the typical borrower will pay more than $520 to repay a $375 loan. The annual percentage rate on even one payday loan is astronomical, ranging from 200% to 500% or more.
Payday loans have been a particular problem for members of the military in recent years. Companies that offer payday loans, refund anticipation loans, auto title (auto pawn) loans, and rent-to-own arrangements, as well as used car dealers that emphasize in-house financing, cluster around military bases and advertise inside bases in official-looking military newspapers.
Because of these problems, federal law regulates these services for active duty personnel. The rules limit to 36% the annual percentage rate that lenders can charge servicemembers who are on active duty for more than 30 days or their dependents in extensions of consumer credit, including payday loans. The rule applies to loans for 91 days or fewer and in an amount of $2,000 or less. This means, for example, that now a payday lender cannot charge a servicemember more than $1.38 in interest on a $100 loan for two weeks. Payday lenders are not permitted to roll over loans to military personnel or their dependents either, unless the new loan has more favorable terms, such as a lower interest rate.
Some states also have laws aimed at curbing payday loan abuses, including laws limiting interest rates to 36%. Even in states with laws regulating payday lenders, you should still beware of payday lenders affiliated with American Indian tribes. Generally, Indian tribes cannot be sued in state court. Some payday lenders offering loans over the Internet associate themselves with an Indian tribe, claiming state laws do not apply to them. These lenders offer very high-cost payday loans and do not comply with state consumer protection laws.
The bottom line: A payday loan is a very expensive way to borrow money.
This is an excerpt from Nolo's Solve Your Money Troubles: Debt, Credit & Bankruptcy, by Margaret Reiter and Robin Leonard.