In counseling students on money management, I occasionally hear about using so-called “payday lenders” or installment loans.
Don’t do it!
A payday loan is a loan to a borrower in anticipation of paying back the loan in full when the borrower is paid by their employer, hence the name. Sometimes these loans are advertised as a “cash advance”, with the lender providing funds now, which will be paid back within a week or two. Once the borrower receives his paycheck, he pays off the loan. Sounds simple enough.
The problem with these short-term loans is that often borrowers get trapped in a cycle of needing money now to pay current bills, such that a payday loan becomes a normal recurring event. The lender typically charges a “convenience fee”, which when calculated as an annual percentage rate may be in the range of 300-500% or more. And that is because a fee of, say $15 to borrow $100 sounds like 15%, until you stop to consider that it’s 15% for 2 weeks until payday. A borrower who pays that $15 every two weeks is paying an annual percentage rate (APR) of almost 400%.
Installment loans are similar, but allow the borrower to make a series of installment payments on the loan over time. The problem with that approach is that often borrowers have issues with cash flow and being able to make payments, so many times the loans are renewed and extended, effectively locking the borrower into a cycle from which it is extremely hard to escape.
Having said all that, and not meaning to unfairly characterize payday and installment lenders as legal loan sharks, the problem with most of these loans is that they are borrowed by those least equipped to be in a position to pay them back. Obviously that is a much broader commentary on our economy and society, but it is an inconvenient truth. The lenders are required to disclose the exorbitant effective annual percentage rate clearly and in large print. But the borrowers still borrow.
Some payday lenders advertise that a $19 fee on a $100 two-week loan (an effective 495% APR) is better than a $35 overdraft fee or a $45 NSF bounced check fee. In each case, the consumer knows the ramifications of their actions, but many borrowers are not sophisticated and well versed in finance, so out of desperation they often choose from a long list of very bad alternatives.
What can you do about it? Don’t let it happen to you!