Payday loans certainly get a bad rap. Some consider them evil or predatory. Is that fair or is it an oversimplistic view of a credit source with extremely high default rates?
Payday loans are expensive. There is no question about that. The typical payday loan has interest rates ranging from 300% to 500% APR. The real question is not whether payday loans are predatory or evil but whether they are better than the alternative.
To illustrate, payday loans are a bargain, if you need to fix your car to get to work and keep your job. Payday loans are also cheaper than other sources of credit, such as a bank overdraft fee. Banks often charge a $35 overdraft fee for every transaction if you don’t have sufficient funds in your account. On a$20 missed payment, that is the equivalent of a 4,258% APR. Or a 852% on a $100 overdraft. So getting a payday loan could be much cheaper than bouncing a check.
That is not to say you should get a payday loan. They are an expensive source of credit you should only consider in emergencies and if you can repay it within a short period.
In this guide, we’ll cover:
- How payday loans work.
- The payday loan trap.
- Who is taking out payday loans and why?
- Where payday loans are legal.
- Payday loan alternatives.
- How to find the best payday loan.
Learn everything you need to know if you are considering this financing option.
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 repay 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.
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.
That is where the situation takes a turn for the worse.
The payday loan trap
In the worst of cases, payday loans can push borrowers into a cycle of debt that is difficult to escape. In our previous example, there is no way John 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.
Over 80% of payday loans are rolled over or followed by another loan within 14 days. In other words, eight out of 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 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.
Further, the average borrower is in debt for 7 months, which amounts to 14 cycles of payday loans and fees. The one simple loan turns into an ordeal that goes on for more than half of the year.
Who is taking out payday loans and why?
According to The Pew Charitable Trusts, the following groups have higher odds of taking out payday loans:
- Individuals between the ages of 24 and 49.
- People without four-year degrees.
- Individuals who rent their homes.
- Those who are divorced or separated.
- African Americans.
- Households that earn less than $40,000 per year.
- People who are disabled.
And what is driving these groups to borrow?
Seven out of ten borrowers spend the loan proceeds on ordinary, recurring expenses (e.g., rent, mortgage, utility bills, food, or credit card bills). Only 16% borrowed due to an unexpected expense like a car repair or medical emergency.
The truth is, 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% of American households could only replace nine days of income with cash savings.
However, America’s top earners are not doing much better. On average, the top 20% of American households only have enough savings to replace 52 days of income. Statistics like these explain why so many consumers fall prey to fast cash offers, even when the interest rates are 400% APR and higher.
But are the payday lenders to blame?
Are payday loans a necessary evil?
Payday lenders will argue that interest rates of 400% to 1,000% APR are a necessary evil. They say they have to charge that much 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%, according to a recent report by Ernst & Young. Cash America, the largest payday loan company in the country, had a 2016 net profit margin of 0.87% (source). QC Holdings, a leading payday loan provider in the U.S. and Canada, had a net profit margin of -3.78% (source). Compare those figures to the net profit margins of Bank of America (21.39%) and Wells Fargo (24.98%).
Compare that to the consumer financial services industry as a whole, which averaged a pretax profit margin of over 30%. When states cap interest rates on payday loans to more reasonable levels, such as 36% APR or lower, payday lenders are regulated out of business.
Take for example New York where payday loans are capped at 25% APR. There isn’t a single payday loan store in the “Empire State.”
So while the rates are astronomical, they are high so that lenders can account for the risk and turn a modest profit. However, state governments are responding with varying levels of regulation.
Payday loan regulations by state
Some states are opting out of the payday loan business altogether while others are drawing lines on what is legal and what is not. According to the National Conference of State Legislatures, the payday lending state statutes as of 2018 are as follows;
Arizona, Arkansas, Washington D.C., New Mexico, and North Carolina prohibit payday loans altogether.
Connecticut, Maryland, Massachusetts, New Jersey, New York, Pennsylvania, Vermont, and West Virginia do not have specific payday lending regulations. However, they do require payday lenders to comply with the interest rate caps set on consumer loans.
37 states have specific statutes that allow payday lending.
Here’s a look at the payday loan statutes by state:
Despite these regulations, payday lenders can still be found in most all 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. Being so, you need to know the laws in your state so you can identify if lenders are legitimate.
What are the best payday loan alternatives?
What other options can you consider when you are strapped for cash but aren’t ready to pay 400% or higher APR?
Reduce your expenses
Analyze your budget to see if there is anywhere you can cut down on your spending. For example, can you get more creative with your meal planning to save on groceries? Can you carpool to cut down gas expenses? Make a list of how you save more and put it in action.
Find a side job
If you keep coming up short on cash, investigate potential side gigs you can pick up in your spare time. Examples include content writing, transcribing, translating, or being a virtual assistant. You may find it surprising how many jobs you can do from home.
Sell unneeded items
Before you decide to borrow, look around your home to see if you have any items of value that you no longer need. If you do, selling them can get you the quick cash you need and you won’t have to worry about paying anyone back. Facebook Marketplace and Craigslist make it easy to connect with buyers.
Take out a personal loan
Personal loans offer better rates and terms than payday loans. If you don’t think you will get approved, you may be in for a surprise. Many online lenders have cropped up which cater to the full range of credit scores. You can apply without hurting your credit score and will get an answer in minutes.
Apply for a line of credit
Lines of credit offer flexibility and quick access to cash. Rates vary from single digit APRs to rates that are higher than the average payday.
Get a credit card cash advance
If you have a credit card, you can check to see if it allows cash advances. Most do and the rates will be lower than payday loans while the repayment terms will be more flexible.
Borrow from your 401(k)
If you have a 401(k), you likely have the option to borrow against it. Doing so does not require a credit check. Further, loan terms usually go up to five years and interest rates are competitive. The drawback is you your investments won’t grow until the loan is repaid.
The bottom line on payday loans
While payday loans may seem like the only option in some scenarios, remember they are not. Alternatives like these can help you get the money you need without such high interest rates. Having said that, payday loans can be much cheaper than losing your job, paying an overdraft fee, or a reconnection of electricity service fee.