Payday loans tempt consumers with a little extra cash before their next paycheck arrives, but with average interest rates that exceed 400%, it's difficult to call them anything other than legalized loan sharking.
The Washington, D.C. City Council last month voted to
eliminate an exemption to district law requiring a 24% cap on consumer loans. Several states, including Ohio, also are considering payday loan interest rate caps this year, the
Center for Responsible Lending says. The U.S. Congress passed the Military Lending Act last year,
restricting interest rates to 36% for U.S. service members and their families. The law is beginning to be implemented this month.
The major problem is that although payday loans are advertised as one-time, quick-and-easy loans for an emergency, the reality is quite different.
"Several studies have shown that payday lenders tend to charge the maximum permissible rate allowed by state law," says Uriah King, policy associate at the Center for Responsible Lending. "The only consistent exception we see to this is when some payday lenders offer the first loan for free.
"That's because payday lenders don't compete on offering the best price or service -- they 'compete' in the sense that lenders work very hard to get people in the door and keep them by trapping them in a series of hyper-expensive, repeat transactions that the borrower can't really afford to pay back without taking another loan. Borrowers that don't have $300 now won't have $350 by their next paycheck, and also be able to pay their regular expenses like rent, food and utilities," King says.
A payday loan begins a vicious cycle requiring the full repayment of a very expensive loan in a very short time period, King says, ensuring borrowers will return again and again without ever truly paying off the loan. "This debt trap is the lifeblood of the industry -- on average, loans going to a payday borrower taking out one or more loans per month makes up nearly two-thirds of the industry's revenues," he says.
What to Do
It's best to avoid payday loans and other forms of predatory lending at all costs. Instead, the first step you should take if you find yourself in debt and needing cash is to address the underlying problems that have placed you in that position in the first place.
Until you address your financial fundamentals, you will continue to be plagued by your lack of cash and be tempted by these ridiculously overpriced loans. Instead, you need to begin to create an
emergency fund in anticipation of unforeseen events.
While many who seek out payday loans feel they have no alternative, there are actually a number of ways people can secure money at much better rates than payday lenders offer. Here are some options that will cost you far less than a payday loan:
Friends or family:
Although borrowing from family and friends can get quite ugly if you don't pay back what you promised, this can be a source to help tide you over in a tight spot. You should take the initiative and approach them with a personal loan contract that explicitly states the amount of interest you will pay them back. This will mean that you are entering into a legal contract (just like with the payday loan lender) and they can take you to court if you fail to pay, but it is highly unlikely that friends or family will charge you 400% on any money they loan you.
One reason that people say they need to go to payday lenders is because they have poor credit and can't get a loan anywhere else. Even if you have terrible credit, you can get a loan for less than 30% from person-to-person lending sites such as
Prosper.com. This is a site where you tell why you need the loan and other people will decide whether to fund your application, bypassing the banks. The people that lend you money get higher interest than they could earn elsewhere, while you pay much less than you would to a payday lender in interest.
Cash advance from your employer:
You may want to turn to your employer if you are having a bit of financial trouble. Companies will sometimes grant true paycheck advances to employees. Unlike payday loans, these advances usually come with no charges or interest and will be automatically deducted from your next paycheck. You need to talk to the personnel department to see if something like this is possible.
If you are self-sufficient and need money for a one-time expense that threatens your livelihood, you can apply to
Modest Needs for money to help you overcome the obstacle. This is a grant -- meaning that there is no interest and the money doesn't need to be paid back.
There are many community services that provide emergency assistance. This assistance can come from government programs, non-profit organizations and religious groups. If the money need is due to basic necessities, such as food, clothing or heat, these programs may be able to help out.
Talk to creditors:
If one of the reasons you need the loan is that you have too much debt and can't pay off what you owe, talking with your creditors may be a solution. Depending on your situation, creditors may be willing to negotiate partial payments when you agree to create a payment plan. This can allow you to lower your monthly payments so that you are not forced to borrow each month, but will extend the period of time it takes to pay off the debt.
Credit union loans:
Many credit unions now provide personal credit loans to their members at much lower rates than payday lenders -- and payback terms that make it much less likely that the borrower falls into a debt trap. While some banks are beginning to also offer these loans, you have a better chance of finding a credit union that does.
Cash advances on credit cards:
While cash advances are one of the most expensive credit card transactions you can make, they are still far less expensive than payday loans. You need to be careful that the cash advance will not put you over your credit card limit, however, since this can trigger fees and knock the interest rate on that card (and all others that you hold) to the top rate. In this case, you should ask for a higher credit limit before making the cash advance.
If you are a member of the military, there are a number of companies that offer personal loans to military personnel. These loan rates are usually higher than credit card rates, but still far below what payday loans charge.
While the alternatives to payday loans may, in some cases, take a bit more work to secure, they will save you from tremendous financial headaches and debt traps in the future. They're well worth the time and energy they take to complete.
Jeffrey Strain has been a freelance personal finance writer for the past 10 years helping people save money and get their finances in order. He currently owns and runs SavingAdvice.com.