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Payday loans can seem like a lifesaver if you need cash quickly, but the high fees and short payment terms can lead to a cycle of debt.
A payday loan is a short-term loan for a small amount, typically $500 or less, that’s typically due on your next payday, along with fees.
These loans may be marketed as a way to bridge the gap between paychecks or to help with an unexpected expense, but the Consumer Financial Protection Bureau says that payday loans can become “debt traps.”
Here’s why: Many borrowers can’t afford the loan and the fees, so they end up repeatedly paying even more fees to delay having to pay back the loan, “rolling over” or refinancing the debt until they end up paying more in fees than the amount they borrowed in the first place.
How payday loans work
Payday loans may go by different names — cash advance loans, deferred deposit loans, check advance loans or postdated check loans — but they typically work in the same way.
To take out a payday loan, you may need to write a postdated check made out to the lender for the full amount, plus any fees. Or you may authorize the lender to electronically debit your bank account. The lender will then usually give you cash.
The loan is typically due by your next payday, generally in two to four weeks. If you don’t repay the loan plus fees by the due date, the lender can cash your check or electronically debit your account.
Many states that allow this type of lending set a cap on the loan amount and accompanying fees. Depending on the state, companies may be allowed to charge from $10 to $30 for every $100 borrowed.
The problems with payday loans
The Pew Charitable Trusts estimates that 12 million Americans take out payday loans each year, paying about $9 billion in loan fees. Borrowers typically make about $30,000 a year. Many have trouble making ends meet.
But while payday loans can provide the emergency cash that you may need, there are dangers that you should be aware of:
High annual percentage rates
Say you get a two-week $500 loan that charges $15 in fees for every $100 you borrow. Expressed as an annual percentage rate, that works out to an APR of almost 400%, according to the CFPB.
You typically need to repay a payday loan within two to four weeks of the initial loan.
If you don’t manage to pay back the loan within the short amount of time, you may get hit with additional fees on top of the initial loan fee. Those fees start adding up if you roll the debt over, or re-borrow. The CFPB says nearly a quarter of initial payday loans are re-borrowed nine times or more.
Additional fees can include:
- non-sufficient funds charge, if you don’t have enough money available in your bank account when lenders try to cash your check or electronically withdraw from your account
- late fees or return-payment fees to the lender if you don’t repay on time
- rollover fees, charged on top of the original loan and initial fee to push back your loan’s due date
Won’t build credit
Borrowers with poor credit may not have access to loans with better terms. But payday lenders usually don’t report your payment history to the credit bureaus, which means the loan is not helping you build credit.
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Payday loan alternatives
Though a payday loan can seem like a quick fix, there are other options that can help keep you out of a cycle of debt. Alternatives include:
Credit union loan
If you’re a member of a credit union, you may be able to access lower-interest personal loans. Federal credit unions may also offer members “payday alternative loans” for amounts between $200 and $1,000. These typically come with terms up to six months, an application fee of no more than $20 and APRs of no more than 28%.
In some states, your employer can advance your paycheck with no fees added. It may be up to your company’s discretion, so ask your supervisor or human resources contact about your options.
A debt settlement may affect your credit but could help you resolve your debt and make a fresh start.
Emergency personal loan
These may come with high interest rates as well, but if you need a loan and don’t qualify for lower rates, it’s important to do some comparison shopping. You may qualify for a slightly better rate and longer terms than the storefront payday lender is offering and not know it.Check for prequalification - it's an easier way to shop for loans.
You should look for a loan with a lender who reports to the major credit bureaus. A positive history of on-time loan payments can help you build credit so you can eventually qualify for loans with better rates.
Long term, you can also work on fixing the underlying financial problems that keep landing you at a payday loan counter. Try credit counseling, which could help you develop a budget, and work on starting a savings account.
If you’re looking for a cash infusion, payday loans may end up making your problems worse with their high fees.
A credit union loan, emergency personal loan, debt settlement or credit counseling may cost money or affect your credit, so proceed with caution. But longer term, they may help you build up your overall financial situation, instead of acting as a short-term bandage like a payday loan.