How Payday Loans Work: Interest Rates, Fees and Costs
Rebecca Woods had a $385 utility bill that was past due and when she got notice that her electricity would be shut off, she panicked.
Her first thought was a bad one: Put it on a credit card. She tried, but that reasoning already had been used too many times. Both of her credit cards were maxed out so the transaction was declined.
With 26% interest charged on one card and 29% on the other, this would have been the definition of throwing gas on a fire.
Her next thought was worse: Borrow the money from a payday loan storefront.
Rebecca didn’t know how payday loans worked. She only knew that some of her friends used them when they were in a pinch financially and the store down the street gave them to just about anybody who walked in the front door.
Payday loans are short-term loan agreements. They are supposed to last two weeks, but the average loan repayment time is five months. The average payday loan amount is $375 and borrowers are expected to make a single repayment of the loan. However, because they can’t catch up fast enough, they take out an average of eight loans and pay $520 in interest per year.
In other words, it’s the equivalent of not just throwing gas on a fire, but dousing the flames with fuel, then being surprised you had to run to avoid the explosion.
Lack Of Emergency Fund A Problem
The payday loan industry took in more than $8.5 billion in fees in 2015 from the more than 12 million Americans that used them for car or household appliance repairs, a visit to the emergency room, funeral expenses, money to bail a friend out of jail or any other unforeseen hit on the family budget.
That includes past due utility bills, like Rebecca’s. In fact, the 2012 Pew Charitable Trusts study on payday lending said that most payday loans are used for ordinary living expenses like rent, not for unexpected emergencies.
Still, most American consumers don’t have an emergency fund for any shortfall. Another survey in late 2015 revealed that 63% of Americans couldn’t handle a bill of $500 or more. That followed a 2013 Federal Reserve Board survey that lowered the bar to $400 and found nearly half of America (47%) still didn’t have money to pay that bill.
That is why so many consumers resort to payday loans as alternative financing. As of September, 2016, it doesn’t require much more than filling out an application and having a checking account.
The interest rates on payday loans vary from exorbitant (somewhere close to 400% APR is usual) to absolutely outrageous (as high as 1000% APR in some extreme cases). It is not unusual for the borrower to pay more in interest and fees than the amount borrowed.
That is why in June of 2016, the Consumer Financial Protection Bureau (CFPB) proposed rule changes that would force payday lenders to verify that borrowers could afford to repay loans before lending them money.
Payday Loans Target Military, Low-Income
Payday lenders prey on people in desperate economic situations, meaning low-income, minority families, members of the military and anyone else who has limited credit options.
Payday loans got their name because they are structured around the two week time frame during which most people receive their paycheck. The borrower provides a pre-dated check (timed to coincide with the date the borrower expects his/her next paycheck) or access to his/her bank account to cover the cost of the loan and interest.
The finance charge for payday loans is somewhere between $10 and $30 for every $100 borrowed. When the due date arrives, the pre-dated check is cashed or the lender goes to the borrower’s bank account and withdraws the money. If the borrower doesn’t have enough money in an account to cover the debt, he/she usually will renew the loan and the cycle repeats itself over the next two weeks. That is where the trouble really begins.
Penalties, Fees Make Matters Worse
The CFPB studies show that 80% of payday loans get renewed and 20% end up in default.
If, for example, Rebecca took a $500 loan at $15 per $100 borrowed, she would owe $575 in two weeks. If she couldn’t pay the loan off in full, she would have to renew it, the $75 fee would be applied again and her total would go up to $650. If she still couldn’t pay two weeks later, another renewal would mean another $75 added to the charge.
So just six weeks after borrowing $500, Rebecca would owe $725 and $225 of that in interest.
Default Rates for Payday Loans
High interest rates and fees are just the start of problems you can have with payday loans. Various surveys put default rates for payday loans between 44% and 54%. If you don’t pay or renew the loan, it goes to a collection agency and the phone won’t stop ringing until they collect. Then there are the troubles defaults cause with your bank, which will assess punitive charges for bounced checks. Payday borrowers average $185 in bank penalties.
There also is long-term damage to your credit score. Though some payday lenders don’t report directly to the three major credit reporting bureaus in the United States, most report to the minor agencies. If the debt goes to a collection agency, that agency almost always reports non-payment to the major credit bureaus, which ruins your credit.
Alternatives To Payday Loans
There are ways to handle emergency situations if you are struggling with credit problems.
The quickest solution is to borrow from family or friends, who hopefully offer better repayment terms and interest rates than anyone else. Some churches and cities, like San Francisco, have started their own version of “payday lending” by offering $500 loans at 18% to be paid back over six or 12 months.
If that’s not an option, make a call to a nonprofit credit counseling agency. Most offer free advice on budgeting to help you cut expenses and make money available to repay debts. They also could direct you to debt management programs or debt consolidation opportunities.
Most cities and counties have social service programs that offer help to pay rent and utilities and assist with food and clothing. Many churches offer the same services, though on a smaller scale than government-funded programs.
Ultimately, Rebecca solved her problem with help from her church, a family member and a nonprofit credit counseling agency. The church agreed to pay half her utility bill and her brother picked up the other half. The credit counseling agency helped her form a workable budget that helped identify expenses she could cut and start putting more money toward paying her debts.
She is still considering whether to join a debt management program to eliminate the credit card debt, but the panic of not having electricity in her home has passed.
And she didn’t need a payday loan to keep the lights on.
NA, (2012, July 19) Who Borrows, Where They Borrow, and Why. Retrieved from http://www.pewtrusts.org/~/media/legacy/uploadedfiles/pcs_assets/2012/pewpaydaylendingexecsummarypdf.pdf
Picchi, A. (2016, January 6) Most Americans can’t handle a $500 surprise bill. Retrieved from http://www.cbsnews.com/news/most-americans-cant-handle-a-500-surprise-bill/
NA, (2016, June 2) Payday Loans, Auto Title Loans, and High-Cost Installment Loans: Highlights from CFPB Research. Retrieved from http://files.consumerfinance.gov/f/documents/Payday_Loans_Highlights_From_CFPB_Research.pdf
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Anderson, L. (2015, July 9) Why people who use payday loans aren’t ‘financially stupid’, just desperate. Retrieved from http://national.deseretnews.com/article/5111/why-people-who-use-payday-loans-arent-financially-stupid-just-desperate.html
Dunn, C. (2015, March 31) Payday Loans: Study Highlights Default Rates, Overdrafts As Groups Debate CFPB Regulations. Retrieved from http://www.ibtimes.com/payday-loans-study-highlights-default-rates-overdrafts-groups-debate-cfpb-regulations-1864480