According to the Consumer Financial Protection Bureau, payday loans are short-term, high-cost loans for small amounts. Payday loans certainly aren’t the bargains of the personal finance world, but many people look at these loans as an easy fix for short-term cash flow issues. In reality, these loans are typically not the best choice if you need to borrow money. They can actually cause you to fall into a trap that’s difficult to dig out of.
Find out more about how payday loans work and what they are. Discover the truth about payday loans below.
The Myth of the Easy Payday Loan Fix
Here’s the fairy-tale story behind the popularity of payday loans.
Once upon a time, someone experiences a small, temporary financial setback. For the purpose of this story, imagine that the refrigerator breaks and there is no money in savings to buy a new one. The person needs $500 to buy a new appliance quickly so groceries and perishables can be kept in the home again.
Because payday is two weeks off, the person turns to a payday loan for the cash. After all, they think, they’ll pay off the loan when they get paid and the story will end happily ever after.
Except that’s not always how the payday loan tale plays out. The expensive fees and structure of the loans, along with the person’s current financial status, can cause a much less satisfactory result.
What’s the Truth About Payday Loans?
Often, the true story behind payday loans goes like this.
In the deep, dark woods, the cabin refrigerator goes out and there’s no money to replace it. The cabin owner braves a $500 payday loan to get enough cash to buy a new appliance.
But cabin expenses, such as utilities, groceries and the gas costs to get into town for work daily, don’t go away. By the time payday comes, the expenses have added up, and there’s not enough left over to pay off the short-term loan. The total amount due at this time is $575 to $625 due to finance charges.
The seemingly benevolent payday loan company offers a compromise. Roll the loan into a newpayday loan and take care of the problem next month. All for a small fee, of course, so the amount due now may be $675 or higher.
Payday loan practices are considered so predatory that the Consumer Financial Protection Bureau has enacted numerous laws to regulate how they are handled. One law that it is working toward enacting would add numerous regulations to payday loans, including:
- A full-payment test to determine if someone can actually pay off the debt within terms while also covering day-to-day expenses
- A 30-day cooling-off period that would stop someone from taking out a payday loan immediately after they had three in a row
- Alternate loan and payment option requirements
- Mandatory reporting of payday loans for the purpose of mandating compliance
What Is the Payday Loan Trap?
The payday loan trap occurs when you become caught in a cycle where you never have enough to pay off the loan. Instead, you keep rolling all or part of it into a new payday loan for an additional fee. The amount you owe grows with each cycle, eventually exceeding anything you would be able to pay off within a few weeks or a month even if you had no other expenses.
According to the Consumer Financial Protection Bureau, this is the reality around 60% of payday loan borrowers find themselves in, but you can escape the trap. As with any fairy-tale character caught in the witch’s house or monster’s lair, escape depends on understanding what your resources are and putting them to best use. Some options for breaking out of the payday loan trap include:
- Requesting an extended payment plan
- Using a different type of credit, such as a credit card or personal loan, to pay off the debt so you have a more manageable balance you can pay off over time
- Filing a complaint with the Consumer Financial Protection Bureau or state regulatory offices if you believe the payday lender is breaking the law
How Can You Avoid the Payday Loan Trap?
If you ask Hansel and Gretel whether it would have been easier to avoid the witch’s oven if they’d never started eating the candy house, they’d probably say yes. And it’s easier to avoid the payday loan trap if you don’t agree to a payday loan to begin with.
When you find yourself faced with sudden expenses or money emergencies, there are alternatives available. In many cases, if your only other option is using a credit card, you may be better off doing so and paying off the balance as quickly as you can.
Personal loans are also a better option than payday loans when you must borrow money to handle an emergency. Consider the examples below to see how the math plays out in favor of personal loans.
- Payday loan option. You borrow $500 and must pay back $575 in two weeks. The loan costs you $75 total, and you must pay all of it back soon, potentially putting you in a financial bind again.
- Personal loan option. You borrow $500 at a rate of 14.99% and a term of 12 months. Your monthly payment is $45, and you pay a total of $42 in interest. That’s nearly half the cost of the payday loan, andyou only have to come up with an extra $45 a month to make your payments. It’s a more realistic option for most budgets.
Personal loans may require that you borrow more than $500, and they demand that you have at least fair credit. But if you can take this option, it’s usually better for you in the long run as long as you make appropriate payments on the balance.