The Consumer Financial Protection Bureau, a federal consumer watchdog group, just released plans to further regulate payday lending, a practice that’s viewed as predatory to consumers. While payday loans are certainly popular, they are oft criticized as charging exorbitant fees and interest rates, setting up borrowers to fail and setting them further back financially. Even President Obama lent his support to the idea of further regulation that would help protect consumers.
“If you lend out money, you have to first make sure that the borrower can afford to pay it back,” Obama said.
Here is some vital information on payday loans and why borrowers should be extremely cautious when utilizing them:
What are payday loans?
Payday loans, which are sometimes referred to as cash advances or check loans, are short term loans at high interest rates, usually with loan amounts below $500.
How do they work?
If someone is employed but needs money quickly before they get their next paycheck, whether for an emergency, to pay a bill, fix their car, buy groceries, or any other reason, they can apply for a payday loan. The lender, operating out of a storefront in their community, verifies their employment, bank account, and documents some other information, and then approves an immediate loan for a certain dollar amount. The consumer writes them a check that is dated for the same day their paycheck comes and gives it to the lender.
When the borrower’s payday comes around, the check is cashed and the lender paid off, minus fees and high interest rates.
Who takes out payday loans?
Every year in the United States, about 12 million people borrow nearly $50 billion through payday loans. The vast majority of payday loans are taken out by people of lower financial means but are still employed.
Do payday lenders target certain people?
Payday lenders target people with limited financial education, weak credit, and in low-income areas. While payday lenders argue that they are just aggressively reaching their target market and following the laws like any business, they often come under scrutiny for practices that pray on uneducated or desperate people.
For instance, California sees the highest ratio of payday loan stores per population in six of its counties. Those counties happen to have an average per capita income of between $17,986 and $26,300, compared to the California average of $44,980. They also have an average unemployment rate of 15.8% compared to the state average of 11.8%.
Why are they so detrimental?
Finance charges on payday loans usually run around 15-30% of the amount borrowed. While that may sound like the typical expensive credit card, remember that those charges are amassed in a very short time, like a few weeks, while credit card interest rates are spread out over a whole year.
So if you compared annual percentage rates, payday loans would be around 800% in some cases. In general, payday loans can cost up to 35 times more than borrowing money on credit cards and a whopping 80 times more than borrowing money from the bank for home mortgages or auto loans. Fees on these loans are also ridiculously high, climbing to 574% APR in some states.
But don’t people just take out a payday loan once?
Research shows that taking out a payday loan isn’t just an isolated incident, but a recurring pattern. Reports show that 80% of payday loans are either rolled over or followed by another loan within just two weeks. Of course there are additional fees every time the loan is rolled over.
Of people who take out payday loans, they are paying on these loans an average of 5 months out of the year and usually end up paying $800 for a $300 loan. In fact, 64% of payday loans are extended multiple times, resulting in fees that are more than the original loan amount, the Consumer Financial Protection Bureau stated.
Only a paltry 15% of payday loan borrowers pay their loans off on time without having to re-borrow within 14 days. In California, people who take out six or more payday loans a year comprise more than 50% of all payday loan revenues.
Why is the cycle of taking out loans so dangerous?
Taking out payday loans often starts a cycle of overextended finances and more loans that’s difficult – or impossible – to escape from. With the high fees and interest rates, borrowers often have already spent a good amount of their check once payday hits, and will find themselves short of cash again very quickly, taking out more loans. In this way, payday lenders can be a trap they fall into that spirals their finances out of control. Instead of staying within a budget and paying off debt, amassing savings, etc., a significant portion of their income goes towards fees and interest.
Gary Schatsky, a New York City financial planner and president of ObjectiveAdvice.com, says, “This stuff gets me crazy — preying on folks who can’t afford it. Payday loans are probably one of the best examples of people being taken advantage of or wasting their money. Unfortunately, the people who take them out are either uneducated about finance or think they have no other options.”
Are payday loans legal?
Payday loans are legal, and regulated in 37 states, each with their own rules on allowable interest rates and fees. Minnesota has the lowest annual percentage rate at 196%, all the way up to the aforementioned 574% in Mississippi and Wisconsin.
There is a push for regulation as we mentioned, with even President Obama urging the Department of Consumer Affairs and states to better regulate payday lending.
Are there better alternatives to payday loans?
Financial advisors suggest that almost anything is preferable to a payday loan in case of an emergency, including borrowing from a friend or family, asking your employer for an advance, or even taking out a cash advance or make purchases on a credit card. While that’s not advisable, the 20% or even 30% you’ll pay on a credit card is still exponentially less than a payday loan will cost you. Even pawning something of value or taking a loan against your auto title is preferable over payday loans. But no matter what you do, educate yourself to the risks and pitfalls of various loans and strive to balance your budget and build savings as a safety net.
