What is a Payday Loan and Why They’re a Bad Idea

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What is a payday loan

If you are strapped for cash, you might be looking for options on how to get money fast. Sure, you might be able to ask your parents or best friends for $50 here and there, but what if you need more money?

Perhaps you have heard of payday loans or even considered taking one out. But here’s the thing: payday loans are a trap. It might be easy to get a payday loan, but just like a credit card, it’s hard to get out of the cycle once you have started.

What is a payday loan?

A payday loan is a short-term loan made for one or two weeks. It’s usually a loan made out against your upcoming paycheck or income. Payday lenders usually have a store but they are also available online and it’s usually very easy to get approved. Some would say it’s too easy.

Because a payday lender isn’t a bank, it usually is too good to be true.

How do payday loans work?

When you apply for a payday loan, either online or in-person, you have to write a postdated check with both the amount that you owe and the interest charged. Or sometimes you have to give the lender the ability to withdraw the funds electronically from your bank account when the loan is due, which is usually when you get your next paycheck.

The application is usually approved very quickly and takes less than 20 minutes. All the lenders need is proof of a bank account and proof that you have a job.  When the loan is approved, the money is put into your bank account.

Who would typically get a payday loan?

Payday loan sharks normally target people who don’t have good credit or decent savings. Essentially, the very people who can’t really afford to take out a payday loan. And that’s more people than you might expect. According to a 2019 survey by GoBankingRates, 69% of Americans have less than $1,000 in savings.

However, because payday lenders don’t normally care about things like credit, it’s easy for those with no or low credit scores to get approved. 1 in 3 college-age Americans have considered payday loans. In addition, about 12 million Americans take out payday loans each year, Pew Research found.

How much do payday loans give you?

The maximum amount of a payday loan you can get varies by state and it is illegal in some places, but it’s usually between $300 and $1,000.

But in order to understand the true cost of a loan, you also need to understand how much they charge in interest. Because a payday loan is a short-term loan, usually of around 14 days, it might seem like the interest is low. But it’s not.

Let’s say you take out a $375 loan and the interest is 15%. That means you have to pay $56.25 to borrow $375.

Now let’s break it down into an annual percentage rate or APR. That is how most interest rates on bank loans and credit cards are calculated and give you the true cost of how much your loan cost. If you take the $375, your annual interest rate is actually 391%. That is compared to an average annual interest rate of 15% to 30% for credit cards.

What happens when you are late or don't pay back a payday loan?

The difficulty with payday loans is that if you’re already struggling financially, it might be difficult to pay off the initial loan. If you can’t pay back the loan, you can ask the lender to roll it over. That means you have to pay the original loan amount and interest rate, plus an additional finance charge on top of that.

Why payday loans are a bad idea

Is it bad to get a payday loan? Yes.

That’s because you will get slapped with huge fees. Payday loans come at a huge cost- they have significant interest rates. In fact, their interest rates are often higher than interest rates of credit cards. If you’re already struggling to pay your monthly bills, the last thing you need is to take on more debt.

While payday loans don’t normally show up on your credit report by the major reporting agencies, they can be found if a lender does an application search to find out all the loans you have borrowed. It is likely this will have a negative impact on your chances of getting a loan. If you don’t repay a loan and it goes into collections, then it’s more likely that a debt collector will report you to the major national credit bureaus like Experian and Equifax.

To avoid a payday loan impacting your credit score, pay it off as soon as possible.

How to get out of a payday loan

Unfortunately getting out of a payday loan isn’t easy if your finances are not secure. First, make sure you don’t borrow any more loans. Check to see if the payday lender will give you a payment plan to avoid late fees. Otherwise, try to get a personal loan or another lower-interest debt, preferably with a fixed interest rate to pay off the payday loan.

For example, Upgrade offers personal loans up to $50,000 with fixed interest rates and no prepayment penalties.

Yes, taking on a personal loan means taking on more debt, but it will come at a much smaller cost than a payday loan.

Lastly, try to get extra hours at work or use services like eBay or Facebook Marketplace to sell your clothes and other items to get extra cash to pay off the loan.

How to avoid needing a payday loan in the first place

If you are tempted to get a payday loan, think about it first. Do you really need the money or can you wait until your next paycheck?

If you have a medical or house emergency, consider using a credit card instead. You can also use a credit card cash advance. Talk to your local bank or credit union about a short-term personal loan. The interest will be high, but it won’t be nearly as high as rates from payday lenders.

You may also want to talk to your boss first. Chances are if you explain the situation to them, they might be able to give you part if not all of your paycheck to you in advance.

Alternatives to getting a payday loan

We all sometimes hit a rough patch in our finances. Before you get stuck in a payday loan trap, consider these other options when you need some extra cash.

Set a budget

You can avoid being short on cash in the first place by creating and sticking to a budget. Keep track of all of your expenses and cut out anything you don’t need. You can even use the envelope method and take out cash and put the money you need for two weeks in specific envelopes. You can also take our free course on creating a budget that works.

Create an emergency fund

A bit like a savings account, an emergency fund is there for those unexpected times when you need extra money. If your car breaks down or you get sick, having a few months of living expenses saved up can help you avoid needing to take out a loan in the first place.

Get a sinking fund

A sinking fund is a bit like an emergency fund, but it’s set aside for a specific expense. If you know you will have a big financial expense in the future, you can set aside a bit of each money each month until you reach your goal. That way you aren’t eating into your living expenses when the event comes up.

Two highly reviewed online bank accounts to save both your emergency fund and sinking fund are:

Chime

    • With Chime, you get an FDIC insured deposit account and a savings account.
    • Your savings happen automatically so you don't have to think about it.
    • There are no fees and no required minimum balance.

Credit Karma high yield savings

    • Credit Karma's online savings account is 100% free, no matter your balance.
    • There's no minimum to open.
    • Your account is FDIC insured up to $5 million.

Increase your income

Try to see if you can get more hours at work. Look for creative ways to earn money and increase your income. For instance, becoming an uber driver, selling your used clothes on Facebook marketplace or the Vinted app, or dog walking for your neighbors.

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