Payday Loans – Legalized Loan Sharks?
The rapid expansion of the payday loan industry in the United States demonstrates the need for greater financial awareness and planning, particularly among low-income consumers. Payday loans are small, super-high interest short term loans intended to cover financial emergencies until the next paycheck arrives.
How Payday Loans Work
Let’s say it’s the first day of the month, a financial crisis arises, you’re out of cash, and you have terrible credit. Your car breaks down and you need $300 to pay the repair bill. You will have enough money to pay the repair bill when your next paycheck is deposited on the 15th of the month. But you need the money right now. What do you do? (You should turn to your emergency savings fund. But unfortunately, you don’t have one.) Without any cash, you go to Uncle Vinnie’s Payday Loans, the neighborhood payday loan store.
You write a check to Uncle Vinnie’s Payday Loans for $375 postdated on the 15th. The payday loan store gives you $300 cash and you get your car repaired. When you receive your paycheck on the 15th, you either pay the payday loan store $375 cash, or they cash your original check. If for some reason you can’t repay your loan on the 15th, you can rollover your loan to the 1st of the next month for $450, an additional $75.
The law prohibits usury (the act of lending money at exorbitant interest rates). Payday loans take avoid the usury laws by labeling their charges as a “fee” rather than interest. Fee or interest, it makes no difference. The end result is still the same – you pay out your nose for the loan. The fees in the example above, which are rather typical of payday loans, amount to 600% APR!
The Problem
Payday loans charge exorbitant rates to the people who can very least afford them. The extraordinarily high fees of payday loans lead consumers deeper and deeper into debt.
The damage is so great that most U.S. states either regulate or ban payday loan stores. Payday loans are prohibited in 19 states, and 25 states (plus the District of Columbia) impose heavy regulation. Only six states allow payday loans stores to operate unregulated.
Playing Devil’s Advocate
The payday loan industry contends that it provides a valuable service to a segment of the population with poor credit that banks completely overlook. Is there any merit to this claim? Consumers most often purchase payday loans to avoid bank overdraft fees. The average bounced check incurs about $60 in fees. Depending on the size of the check, the overdraft fees may well exceed the cash advance fees that payday loans charge. Without any cash reserves, a payday loan may be a reasonable choice in this situation.
Plan Ahead
Regardless of whether payday loans or overdraft fees are cheaper, both are completely unnecessary. Overdrafts and payday loans should not be the only two solutions to a financial crisis. Prudent consumers place at least three to six months of living expenses in an emergency savings fund. With a short-term nest egg in place, financial emergencies can be resolved easily.
If you are facing a situation where you must either take out a payday loan or bounce checks, you certainly should consider a payday loan. Let this be a lesson to you that you should put some money away for emergencies. If you have so much debt that you can’t establish an emergency fund, you should get help from a qualified financial advisor.
