How Do Payday Loans Work?

You probably know that payday loans are expensive. But do you know just how expensive? The typical payday loan is a small loan of $375 and has interest rates ranging from 300% to 500% APR . Payday lenders usually advertize the cost of payday loans as a one-time fee of $15 to $20 per $100 borrowed. Borrowers must repay the loan in full by their next paycheck, typically two weeks later. Sadly, that is not the worse of it.

Over 80% of payday loans are rolled over or followed by another loan within 14 days. In other words, 8 out 10 payday loan borrowers cannot afford to repay their loans in full and are forced to pay additional fees to renew them. According to a 2015 study by The Pew Charitable Trusts, 12 million Americans use payday loans every year, spending an average of $520 in fees to repeatedly borrow $375.

Let me say that again: $520 in fees for a $375 loan. Yes, the average payday loan customer pays more in fees than the original loan.

If you are not one of the 12 million Americans who use payday loans, you may wonder how that is even possible.

How Do Payday Loans Work?

Payday Loans look like this. Meet John. He is having trouble paying his bills and making rent on time. So like millions of Americans, he takes a cash advance on his paycheck. He repays his creditors and makes it through another two weeks. Problem solved? Hardly.

Payday loans are different from other sources of credit, such as personal loans, mortgages, or credit cards. You can’t pay payday loans slowly over time. You have to pay them all at once. What payday loans lack in affordability they make up in speed and convenience. Payday loans provide instant cash and are available in storefronts, online, and even in some banks. They are also easy to qualify for. Payday lenders only require two things from borrowers: a source of income and a bank account.

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So let’s say John is $375 short on his rent, which just so happens to be the average amount for a payday loan. John only has to agree to pay a one-time fee of $55 and the cash is his. If your alternative is not paying your rent, a $55 one-time fee doesn’t sound that bad. However, two weeks later the payday loan is due and John’s financial situation hasn’t improved. There is no way he can afford to pay $375 but he can afford the $55 fee required to renew the loan. If John is a typical payday loan borrower, he will do this again and again until he has paid $520 in fees for that initial $375 loan.

Are Payday Loans A Necessary Evil?

Payday lenders will argue that interest rates of 400% to 1,000% APR are a necessary evil to cover the high default rates involved in lending money to consumers with bad credit. They have a point. Payday lending is an easy business to demonize but it’s not a particularly profitable one. Even with the outrageous fees, the average profit margin before tax of payday loan stores is less than 10 percent, according to a 2009 report by Ernst & Young. Compare that to the consumer financial services industry as a whole, which averaged a pretax profit margin of over 30 percent. When states cap interest rates on payday loans to more reasonable levels, such as 36 percent APR or lower, payday lenders are regulated out of business. Take for example New York where payday loans are capped at 25 percent APR. There isn’t a single payday loan store in the “Empire State.”

New York is not alone. There are several other restrictive states, such as New Hampshire, Vermont, Massachusetts, Connecticut, New Jersey, and Maryland, where there are no payday loan storefronts. However, payday lenders can still be found in those states either online or through unlicensed (i.e. illegal) lenders. In fact, online payday lending has tripled since 2007 and rivals the volume of loans issued by storefronts.

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Why Do So Many Americans Resort To Payday Loans?

Seven out 10 Americans are strained by financial issues, such as overwhelming debt or not enough income to pay for monthly expenses. According to a Pew report on “The Precarious State of Family Balance Sheets”, the bottom 20 percent of American households could only replace nine days of income with cash savings.

americans liquid savings

Source: The Pew Charitable Trusts

Surprisingly, America’s top earners are not doing much better. On average, the top 20 percent of American households only have enough savings to replace 52 days of income. Statistics like these explain why so many consumers are falling prey to fast cash offers even when the interest rates are 400% APR and higher.

Strapped for cash but not ready to pay 400% APR? Consider these payday alternatives

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Payday Loans Are Not The Problem

Although protecting consumers from falling into cycles of debt is a noble goal, payday loans are not the real problem.

Most customers use payday loans to pay for basic monthly expenses, such as rent and groceries, not luxuries. Median earnings have stagnated since 2000. From 1979 to 1999, the average worker saw his income grow by 22 percent. From 1999 to 2009, income only increased by 2 percent. Access to credit, on the other hand, has exploded.

reasons consumers take for payday loans

Source: The Pew Charitable Trusts

Among households with incomes of $75k or more a year, one in three (33 percent) say they are living “on the edge financially.”  Even in households earning more than $100k, 25% say they sometimes live from paycheck to paycheck and have little to no savings to fall back on.

Poverty and poor money management skills are the real issues. But, of course, those problems are a little harder to fix than capping interest rates on payday loans.

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