For many Americans, managing finances is a paycheck-to-paycheck way of life. Even those who carefully balance their expenses with tight incomes can easily run into trouble when unexpected events arise.
When people face emergency expenses like car repairs or hospital visits, but they don’t have the cash on hand to pay for them, they’re forced to look for a way to make ends meet. Payday loans are one quick-fix option to pay for life’s unexpected necessities.
These short-term loans, also called cash-advance loans, work by providing an immediate loan for an amount based on a portion of your expected paycheck. The lender, usually a small credit merchant, essentially uses an upcoming paycheck as collateral. They consider the amount of the borrower’s wages and their credit risk when they issue the loan, which typically comes with a term of less than 30 days.
Payday loans can indeed offer people immediate relief, but they come at a high cost, and one that could be more damaging to their long-term financial stability.
How Payday Loans Can Cause Harm
In general, payday loans are considered predatory because they take advantage of desperate situations by charging a high interest rate that can trap borrowers in a cycle of debt.
Lenders are required by law to disclose the terms of the loan, including any interest rates and fees, but many borrowers either overlook those conditions or accept them in desperation. The interest on payday loans can be as high as 500%, so the cost of repaying that loan could compound quickly and consume someone’s finances.
According to the Pew Charitable Trust, the average payday loan is only $375, and the average borrower ends up paying $520 in fees.
The Hidden Costs of Payday Loans
Sometimes, borrowers can get trapped in a cycle of taking out another payday loan to fund the fees and expenses of their original loan. Obviously, that situation has several destructive effects on a person’s financial health, including preventing them from saving and increasing their expenses. If you’re trapped in a payday loan cycle, it can be very difficult, if not impossible, to pay off your debts and put your money toward long-term goals like buying a house or a new car.
Laws on payday loans vary from state to state, but oftentimes these loans avoid stricter consumer-friendly regulations because they are made in smaller amounts and by smaller lenders.
1 in 5 borrowers will end up taking out ten or more payday loans in succession before finally being able to pay them back. It is a never-ending cycle of debt. And who tends to fall prey to this cycle? According to the Consumer Financial Protection Bureau (CFPB), these borrowers tend to be individuals earning under $30,000 per year or even the unemployed.
A payday lender will charge anywhere between $10-$30 for every $100 borrowed. Assuming a $15 fee, this results in a fee over 400% over a year! And, if you are one of the 70% that have to extend the loan, expect to get hit with renewal fees each time, an increased balance, and accumulation of interest on that increased balance.
If you are unlucky enough to default on a payday loan, the lender has the legal right to send your debt to a collections agency and/or even file criminal charges against you. At that point, an impacted credit score is only one of your problems (and no, paying back payday loans on time does not increase your credit).
The Legality of Payday Loans
While this may surprise you, payday loans are not illegal – but they are heavily regulated. Depending on what state you live in, your state may give lenders freedom in setting fees and repayment policies, but limit the amount you can borrow based on an amount or a percentage of your monthly income. Some states have outlawed payday lending in its entirety or effectively made the business unprofitable by capping interest rates. Other states take a middle ground approach, limiting interest rates while keeping lenders profitable, limiting the number of loans a borrower can take out, or setting a minimum loan term.
How to Avoid Needing a Short-Term Loan
Why do people take out short-term loans? A Pew survey showed that most borrowers use short-term or payday loans to cover regular, recurring expenses. In this case, a payday loan is nothing but a bandage fix. Without fixing the root cause of the issue, you end up feeding into the never-ending cycle of debt. So, how do you address the root cause? Here are some ideas.
Develop a Stronger Budget
Use a budget tracker to break out your monthly expenses and analyze where you can cut back. See which monthly services you really need and even negotiate payments where you can. Avoid eating out and impulse buys.
Additionally, sit down and write out when all your bills are due and which ones charge late fees. Some may accept late payments without reporting the late payments to credit agencies or charging major fees. While this shouldn’t become a regular habit, making late payments (even with fees) can be your form of a payday loan with no strings attached.
Pay Back your Debt
Depending on the size of your debt, simply writing out all your balances and allocating a bit of cash each month to gradually pay them back may be enough (consider auto-pay, where available). If you feel your debt has spiraled out of control, consider negotiating with your creditors to lower your balances and/or set you up on a payment plan. Some creditors may even let you pay a lump sum in exchange for forgiving the rest of your debt. Other options involve credit card balance transfers to a card with less interest, debt consolidation loans, and even debt settlement.
Raise your Credit Score
Raising your credit score is a marathon, not a sprint, but it will help you get lower interest rates and get to a financially healthier place. The easiest way to start is to make your minimum payments on time and ask for a credit line increase, so you bring your overall credit utilization down. Another quick, good strategy is signing up for Experian Boost, which is a service directly provided by one of the major credit agencies. It’s an instant boost in your credit that works by giving you credit for paying bills on time that wouldn’t otherwise be reported to credit agencies, like utilities, TV, phone, internet—even streaming services! The average user boosted their score by 12 points.
Even if you are living paycheck to paycheck, you can still save! Cutting back on impulse buys and eating out, couponing, downsizing, minimizing subscriptions, and reducing transportation expenses, are just some ways to save on a low-income.
Make Extra Cash
Whether you take on gig work, freelancing, ridesharing/delivery, taking online surveys, one-off handyman work, babysitting, housekeeping, etc., there are many ways to make extra cash and still maintain control over your schedule. You may even be surprised to know which major companies started as side hustles.
Alternatives to Payday Loans
On-demand pay (also known as early wage access) is the best alternative to payday loans. If you have access to an app like Rain, you can get your money any day instead of having to wait for payday. Currently, Rain is only available to employees at companies that have already partnered with Rain.
Through Rain, you can withdraw your funds for free or for a very small fee (depending on how fast you need your funds). The fee is only a few dollars and is sort of like an ATM transaction fee. There is no interest on the money you withdraw from Rain because instead of having to pay it back, it comes directly out of your paycheck. That means you don’t even have to think about it and you don’t have to pay extra interest just for using your paycheck early.
If you are interested in using Rain but your employer has not signed up yet, send them the link to this website and ask them to fill out the “let’s chat” form so we can get them started (it is free for your employer)! If you have a Rain account or need help setting up your Rain account, please text or call us at 424-369-7246. You can also email firstname.lastname@example.org with questions about your account.
About the Author
Giuseppe is a financial advisory and investment management professional with work experience serving mass market and ultra-high net worth investors. He has worked for independent investment advisory firms as well as an international private bank and trust company, supporting teams managing over $700 million within a firm responsible for over $100 billion of client assets. He graduated with a degree in business administration from the University of Southern California, during which time he also studied at the London School of Economics. Giuseppe enjoys educating others and is an avid proponent of financial literacy as the single most impactful economic empowerment tools. On his free time, Giuseppe mentors current USC students on their professional development.