If you’re short on cash between paychecks or have an unexpected financial emergency, a payday loan can be a tempting option to help make ends meet or access money quickly. However, these short-term loans, which typically mature on the next payday, are extremely risky. They come with very high interest rates and other fees. The interest rate on payday loans in the United States ranges from 154 percent to 664 percent.
Equally troubling, payday loans are often marketed to those who can least afford them — those who make less than $40,000 a year. While this type of lending is advertised as a short-term loan, payday loans can create a debt cycle that is difficult to break out of.
What is a Payday Loan?
A payday loan is typically a short-term loan with a term of two to four weeks that does not require collateral to obtain. These loans are usually repaid in a single payment on your next paycheck when you receive Social Security or retirement income.
In most cases, payday loans are made for relatively small amounts, often $500 or less, with the average borrower getting a payday loan for around $375. In some cases, payday loans can be taken out for larger amounts.
To obtain a payday loan, borrowers are asked to write a personal check for the amount of the debt plus any financing fees. If the loan is not repaid on time, the lender will deposit the check to get their money back. Some lenders may require authorization to electronically withdraw the money from your bank account instead of requiring you to present a personal check.
Payday loans generally do not involve any credit checks, and your ability to repay the debt while paying your day-to-day expenses is not usually considered as part of the application process.
Who Usually Takes Out a Payday Loan?
Payday loans are most often taken out by people who have constant liquidity problems as opposed to borrowers who are in financial distress. A study of payday loans found that 69 percent of borrowers initially took out a payday loan to cover recurring expenses such as utility bills, rent, mortgages, student loan payments, or credit card bills. Only 16 percent of borrowers use payday loans for unexpected expenses.
These loans are also commonly used by people living in neighborhoods and communities that are underserved by traditional banks or who do not have a bank account with a major financial institution. Payday lenders operate in 32 states, although a handful of states have recently passed reforms that require payday lenders to move from a model that requires borrowers to repay the loan in full with their next paycheck to a more equitable and less risky installment repayment structure.
What are the risks of payday loans?
Because of the many risks associated with payday loans, they are often viewed as predatory.
First off, payday loans often come with astronomical interest rates. Those who take out such loans have to pay between $10 and $30 for every $100 borrowed. A typical payday loan with a two-week repayment period and a fee of $15 per $100 equates to an APR of nearly 400 percent.
Many payday lenders also offer extensions or extensions that allow you to simply pay the borrowing fees on the loan’s due date and extend the balance due for a longer period of time. This can be a slippery slope, resulting in borrowers quickly being overwhelmed with fees and interest that apply. According to recent data from the Pew Charitable Trusts, the average borrower takes five months into debt to fully pay off what should be a one-time payday loan. Borrowers pay hundreds of dollars more in fees than originally advertised for the loan.
Are Payday Loans Ever Worth It?
With their high interest rates and fees, a payday loan is rarely a good idea. The fees alone cost Americans $4 billion a year. Because the costs associated with these loans are so high, borrowers often struggle to repay them and go deeper into debt. Therefore, it’s a good idea to carefully consider your options before taking out a payday loan.
However, if you have an urgent need or need cash fast and you are confident that you can repay the loan with your next paycheck, a payday loan can make sense. These loans may also be worth considering if you have no other financial options or bad credit and would not qualify for a traditional loan.
Alternatives to payday loans
Before taking on the significant financial risks involved with a payday loan, examine other alternatives that may be less expensive. Some of the options to consider include:
- Borrow money from family or friends: Payday loans should be the last resort. If you have family or friends willing to help, borrowing money from loved ones may be better than a predatory lender.
- Home Loans: Tapping into your home equity offers a far more competitive interest rate than a payday loan. Home equity loans are a popular way to access cash to consolidate debt or pay for other major or unexpected expenses. To access your home’s equity, however, you must meet certain requirements, including good credit, a stable income, and a debt-to-income ratio of 43 percent or less.
- Continued payment of wages: Some employers offer the opportunity to take a wage advance. The employer provides you with a short-term loan that you would pay back from your future wages. Typically, the employer sets guidelines on how and when the money must be paid back.
- Private loan: For those with good credit, a personal loan can be a safer and more affordable borrowing option. And if you need cash fast, some online lenders can provide personal loan funds in just a day or two.
- Selling unwanted items: There are various online platforms that you can use to turn all sorts of unwanted items into quick bucks. Some of the most popular options are eBay, Facebook Marketplace, Craigslist, and OfferUp. If it’s unwanted or used clothing that you want to turn into cash, there are also resale platforms online that specialize in this niche including ThredUp, Poshmark and TheRealReal. Many of these marketplaces deposit sales proceeds directly into your bank account, while others, like OfferUp, allow you to sell locally and receive cash directly from buyers.
- sideline: Thanks to the proliferation of apps and websites like Thumbtack, TaskRabbit, Rover, Uber, and Lyft, it’s possible to do a few odd jobs in your free time to quickly rack up an extra income. TaskRabbit, for example, allows Taskers to do everything from assemble furniture for extra money to home delivery, gardening, and TV assembly. Rover is a pet sitter and walker network where pet lovers can offer services.
With high interest rates and tight repayment terms, payday loans are rarely the best choice when you need cash. Often these types of loans trap borrowers in an inevitable cycle of debt.
Before you take out a payday loan, you should consider the many alternatives. Borrowing money from family or friends, opening a home equity loan, or taking out a personal loan are far less risky options. And if you’re not in a hurry for the money, there are more ways to earn the extra money you need, including selling unwanted items or taking on a side job.