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What is a Payday Loan
A payday loan is a short-term, high interest loan (generally for $500 or less) that is designed to help bridge the gap between the borrower’s paychecks.
How it Works:
The borrower typically writes a personal check for the dollar amount borrowed (including finance charges) and receives cash in return. The payday lender will have access to the borrower’s checking account either electronically or through a post-dated check. If the borrower doesn’t repay the loan on or before the due date, the lender can cash the check or electronically withdraw the money from the borrower’s account.
Requirements to get a Loan
The process to take out a payday loan is quick and convenient. The only requirements for a loan are a driver’s license, a Social Security card, proof of income and a bank account number.
Payday Loan Example:
Imagine your car breaks down and you have to borrow $500 from a payday lender for the repair. The payday lender will loan you the $500 but will charge you an additional $50 in financing fees. You will write a post-dated check for $550 to the payday lender and the lender will advance you the $500. After a set period of time (usually 2 weeks) you will be required to pay back the payday lender the $550 or to write another post-dated check for the amount you cannot pay back plus an additional financing fee.
APR on Payday Loans
APR stands for Annual Percentage Rate and is the cost of borrowing a certain dollar amount including the yearly interest rate you’ll pay if you carry a balance (i.e. do not pay back the loan when due). APR tells you how much it will cost you to borrow for one year. If you pay back the loan in less than one year, you will pay a lower rate.
For example, if we assume your $550 payday loan for auto repairs ($500 car loan with a $50 financing fee) must be repaid in 14 days, your APR would be approximately 260%. Or, in other words, if you didn’t pay off the loan for an entire year, you would end up paying 260% of $500, which would result in you paying $1,304 for a $500 loan.
In comparison credit cards have an average APR of around 20% and mortgages have an average APR of around 4%.
Shocking Facts about Payday Loans:
I’ve compiled some of the most shocking facts about the payday loan industry from the Milken Institute report below:
Source: http://www.milkeninstitute.org/publications/view/601
- In the U.S. 12 million people borrow nearly $50 billion a year through payday loans.
- The rates charged on payday loans can be up to 35 times the rates charged on credit card loans and 80 times the rates charged on home mortgages and auto loans.
- The average payday loan is $375 and is typically repaid within two weeks.
- Most borrowers owe payday lenders for five months out of the year and end up paying $800 for a $300 loan.
- The estimated annual percentage rate on payday loans in the U.S. ranges from a low of 196% in Minnesota to a high of 574% in both Mississippi and Wisconsin.
- To put payday loans into perspective, the interest cost of using a credit card to finance $300 of debt is roughly $2.50 for two weeks and $15 for three months. In contrast, the fees for a payday loan are $45 for two weeks and $270 for three months.
How do alternative loans differ from payday loans?
Alternative loans differ from traditional payday loans in several ways. An alternative loan, usually an installment loan, is structured so that the borrower can successfully repay the debt. The typical payday model structures the loans with such a high price point because lenders expect a higher level of defaults, or people who cannot repay the loan.
How does this work? Alternative loans give consumers longer to repay the loan as opposed to the typical 14-30 days in which most payday companies structure their loans. Many also charge an interest rate as opposed to fee based pricing. This means that if the consumer has the ability to repay the loan faster, they can repay early, and achieve a savings. Payday lenders are often in the several hundred percent range, so compare the APR on any alternative you consider.
Flexibility and fair pricing can help consumers successfully repay their loans. Another benefit to this loan structure is credit reporting. Typical payday companies are unable to report to credit due to the setup of their loans. They don’t “qualify” for lack of a better word to report to credit. Since an installment loan is set up just as any other auto loan or mortgage would be, a lender can report a borrower’s successful payment history, which can help a credit profile.