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How millions risk falling into the debt trap of 400% annual interest rate loans

Daily Ticker

People needing quick cash would probably scoff at an effective 400% interest rate for a loan they couldn't afford to pay off in time from the start. Yet millions of Americans appear to risk falling into this trap by taking out payday loans. And Consumer Financial Protection Bureau Director RIchard Cordray this week said the watchdog is worried that "too many borrowers slide into the debt traps that payday loans can become."

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Also known as "cash advances," these are typically expensive, short-term loans of less than $500 that offer borrowers easy access to money needed in a pinch to pay bills when they may not qualify for other credit. The Los Angeles Times reports these loans are usually advances on a paycheck for two weeks, with a flat 15% fee or an interest rate that sounds reasonable. The problem is that costs can quickly multiply if the loan is not paid off in time or if the borrower has to take out another loan to pay off the first, which many end up needing to do.

According to the Center for Responsible Lending and in comments echoed by the CFPB's Cordray, the annualized interest rate on some of these payday loans ends up being 300% or 400%, using the formula for APR based on the U.S. Treasury's Truth in Lending Act.

In a report released earlier this week, the CFPB revealed that four out of five payday loans are rolled over or renewed within 14 days and that the majority of all payday loans are made to borrowers who renew their loans so many times that they end up paying more in fees than the amount of money they originally borrowed. The study was based on data from 12 million storefront payday loans made over a one-year period.

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The CFPB, which has oversight of this industry and is looking to make reforms to better protect borrowers, held a hearing on payday loans in Nashville this week.

In the accompanying video we talk to Gary Kalman, executive vice president of the non-partisan nonprofit Center for Responsible Lending, which has researched the issue extensively. Kalman explains why the center found these loans to be "debt traps" that can drive borrowers to bankruptcy even though they were taken to help pay regular monthly expenses.

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He also responds to arguments made by the payday loan industry that these loans are an essential option for people living paycheck to paycheck and capping their rates will eliminate lenders from the market.

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