Payday Loans Can Cost You Lots of Money

/ BY / Personal Finance

Have last month's holiday expenses have left you short of funds this month? You may be considering getting a payday loan to help tide you over until your next paycheck arrives. Before you borrow from a payday lender, however, you should understand just what you're getting yourself into. Most financial experts believe that payday loans should be avoided whenever possible.

Payday loans, also known as cash advances or deferred deposits, are a way to get a small amount of cash (usually under $500) for a very short term. They’re called payday loans because they’re supposed to help you keep afloat financially until you get your next paycheck.

The biggest problem with payday loans is the rate of interest that you’ll have to pay on them. That interest rate is exorbitantly high—as much as 1,000 percent, according to an article on the U.S. Federal Deposit Insurance Corporation website.

A high-interest cycle

Here’s how payday loans work. Joe Smith needs $300 immediately to buy groceries and pay the electric bill, but his next paycheck isn’t due for two weeks. He goes to a payday lender, who requires him to write a post-dated check for the amount of the loan plus the fee—say $45. ($15 for each $100 borrowed.) The lender agrees to hold the check until the next payday, when it will cash the check to get the money back. Joe writes the check for $345, and then receives $300 in cash.

Paying $15 per $100 borrowed may not seem like such a bad deal—until you look at the interest rate that $15 actually represents. The payday lender is charging $1 in interest a day, which works out to an APR (annual percentage rate) of a whopping 391%! Compare that to the current interest rates of between four and five percent for auto loans, or even 21 percent interest on high-interest credit cards!

Payday loans also make it easy to get trapped into a vicious cycle of high-interest payments. Suppose in two weeks, on Joe’s next payday, he’s still behind in bills and can’t come up with the $300 needed to pay off the loan. He goes back to the lender, who agrees to extend the loan for another two week period. But Joe will have to pay another $45 in loan fees.

If Joe continues to extend the loan for two weeks at a time, in less than two months he will end up paying more in fees than he borrowed in the first place!

Finding alternatives to payday loans

If you’re running short on cash between paychecks, the first thing you need to do is set up a budget to get your finances under control and build a small nest egg that you can draw on if you have a financial emergency. That may mean giving up some of life’s small pleasures—packing a lunch instead of eating out or skipping the Starbucks each day—but the freedom from financial worry will be worth the sacrifices in the long run.

Another alternative is to use a credit card to make some of your purchases or to borrow cash (as long as you understand that money will have to be repaid as well). Even high credit card interest rates look good compared to the interest rates on payday loans. If you’re worried that you won’t qualify because of a poor credit rating, check out these credit card offers for people with bad credit.

Finally, if you feel you have no alternative to seeking a payday loan, at least get to know the protections that you have under your state’s laws. Many states now limit the amount of fees and interest that a payday lender can charge and/or restrict the number of times that a borrower can roll over a payday loan. You can start by checking out the payday laws chart on the National Conference of State Legislatures’ website.

You may also find information on payday loans on your state government website. The agency that handles this issue will vary by state, but good places to start your search are the office of consumer protection, the office of the state attorney general, and/or the state banking and finance department.

Payday loans are small loans that can get you into big financial trouble. Your best bet is to try to avoid them whenever possible.

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Please note your financial situation is unique and our tips & advice presented here may not be appropriate for your situation. CreditCardXpo.com recommends that you seek different advice & opinions from your own accountant or financial adviser who understands your individual circumstances before making any important decisions or implementing any financial strategy.