Payday loans are used by millions of Americans every year — despite steep interest rates that can hit several hundred percent.
What is a payday loan?
A payday loan is a one-to-four-week loan of less than $1,000 that costs about $15 to $30 in fees for every $100 you borrow. When you do the math, that works out to an annual percentage rate (APR) of 360% to 780% for a two-week loan.
The loans are usually offered by specialized payday lenders rather than mainstream banks. To qualify, borrowers need only proof of residence, proof of employment and a valid checking account.
The application process for a payday loan doesn't involve a credit check, and payday borrowing usually isn't reported to the national credit bureaus. So, taking out or repaying a payday loan probably won't hurt or help your credit scores.
But your credit can be put at risk if you don't pay back your loan, warns the U.S. Consumer Financial Protection Board. "Debts in collection could hurt your credit scores," the agency says.
Your scores also can take a hit if payday loan payments make it tough for you to stay current on other bills.
To understand the harm a payday loan can cause a consumer, you might watch the second episode of the Netflix docu-series Dirty Money, which focuses on convicted payday loan kingpin Scott Tucker, now serving more than 16 years in prison.
Tucker’s company, AMG Services, offered predatory payday loans that were intentionally confusing and featured high administrative fees and deceptive customer service practices. Federal prosecutors said the interest rates were as high as 1,000%.
Typically, the interest rate for a payday loan is over 10 times the rate on a credit card, says Federal Reserve Board economist Neil Bhutta, in his study Payday Loans and Consumer Financial Health.
The high costs often force consumers to take out new loans to pay off existing ones — and they get trapped in a debt spiral.
Why people turn to payday loans
Even with such poor terms, payday loans remain popular: 12 million Americans use them every year.
Borrowers who've been thrown out of financial equilibrium and need instant access to cash often have bigger things to worry about than the loans' high price tags.
As of August 2019, high-interest payday loans are illegal in 18 states and the District of Columbia. Three states — Maine, Oregon and Colorado — permit lower-cost payday lending that limits the interest a lender can charge.
Proponents of the payday loan industry have argued that the lenders provide a vital service — offering loans to high-risk borrowers when other mainstream financial institutions can't or won't.
Alternatives to payday loans
Payday loans have been called part of the "democratization of credit." But consumers with low or no credit have options, including credit cards and personal loans with much lower interest rates and more regulatory oversight than payday loans.
Additionally, the National Credit Union Administration (NCUA) allows federally chartered credit unions to offer small-dollar loans called payday alternative loans (PALs). To qualify, all you need is to be a member of the credit union for at least one month.
You might also consider these other cheaper and less painful alternatives to payday loans whenever you find yourself needing quick cash.
And then, get working on building an emergency fund, so you won't find yourself in this sort of predicament again.
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