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Should I Get a Payday Loan? Beware the High Cost of Short-Term Loans

Man signing a payday loan contract
Unexpected costs are a fact of life. Accruing debt to payday lenders doesn’t have to be.

It seems to be a reasonable solution, at least on the surface. You’ve got a chunk of money due right now and a paycheck coming your way in the next couple of weeks. What’s the harm in borrowing that money knowing you’ll soon have the funds to pay it back?

Payday loans, also known as cash advance loans, rely on just that reasoning. Easy to get and easy to spend, the short-term loans distributed from payday lenders require only a government ID stating you are 18 or older, a bank account and proof of income (like a pay stub or Social Security check). With no credit check or proof of financial solvency, you simply authorize the lender to withdraw what you owe, fees included, out of your next paycheck.  In exchange, you can walk away with several hundred dollars, depending on the state, in less than an hour.

According to a 2012 report by the Pew Charitable Trusts, 5.5% of Americans did just that at least once in the previous 5 years. Most often the loans, which averaged just $375, went toward everyday expenses like groceries and utilities. For the 44% of Americans who can’t cover a $400 an emergency expense out-of-pocket, a payday loan seems to stop the bleeding for a spell.

The reality, however, is far more complicated.

Payday loans mean high fees and interest rates

It’s probably no surprise to learn that—when compared to loans from credit cards and banks—the fees for payday loans are exceptionally high, even with heavy regulation. Depending on your state, the maximum amount of application fees may be $10 to $30 for every $100 borrowed.  When you’re in desperate straits, it may look like a reasonable price to have to pay to get out of a mess. But those fees for a 2-week loan can add up to an annual percentage rate (APR) of almost 400%! Compare that with the typical credit card APR of 30% or less.

Yet, that’s only part of the problem.

Payday loans are designed for the debt cycle

While loans from banks, credit unions and credit cards allow you to make payments back gradually in installments, payday loans require that you pay off the entire sum and fees all at once, usually within less than 30 days.

The things is,  borrowers who are barely making ends meet in the first place are unlikely to be able to survive through the next paycheck with such a large portion of it going to pay off the loan. With the option to renew or roll over the loan (or take out a new one to pay off the old), borrowers find themselves in an ongoing cycle of debt.

In fact, according to the Pew report, those who borrowed from payday lenders were likely to have taken out 8 loans in a year. They may have “paid” each back within 18 days, but the cycle of debt clearly had not been broken. By the end of the year, they had paid $520 in fees on that $3000 they borrowed. A loan that started as a stop-gap becomes a cycle that’s hard to get out of.

What to do when you can’t save for “someday”

Of the 12 million Americans who took out at least one payday loan, the majority surveyed by the Pew Charitable Trusts said if payday loans had not been available to them, they would have cut back on clothing or food costs, sold something, put off paying a bill or borrowed from family or friends. They were less likely to turn to an employer, a credit card or a bank for a loan, suggesting their credit history was unlikely to allow it.

If you have found yourself tempted by the short-term solution of a payday loan, be sure you are prepared for the short-term loan period. It takes a lot of $5 bills to pay off a $400 debt. Act now to have that extra money on-hand before it comes due.

Put all those savings toward your debt or your savings.

The bottom line is: avoid payday loans. But if you must take out a high-cost, short-term loan, treat that debt with the same degree of urgency you felt when you went in to get it and be sure you can replenish the hit to your next paycheck before your loan comes due. Only then will you protect yourself from the real risk of payday loans—the ongoing cycle they are designed to trap you in.