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How Bad Are Payday Loans?

Exactly how bad are payday loans? Within the credit industry, no one is more reviled than the payday loan companies. They are notorious for high interest rates and for beckoning some consumers into a self-destructive cycle of debt from which they will never recover.

The payday lending companies say they merely provide a service that people need, and argue that while some people make bad choices there is still a legitimate market for the service they provide.

So really, how bad are payday loans? Below we examine this question in detail:

A Real Need for Fast Cash

One part of the payday lenders’ argument is true: people really do need money quickly due to a variety of circumstances (from health emergencies to surprise car breakdowns). However, the question is whether the terms of the transaction are reasonable.

Let’s dig deeper into the numbers to find our answer. According to the Consumer Federation of America, a consumer watchdog group, a typical payday loan company charges you $17.50 for each $100 you borrow. At first glance, that doesn’t seem egregious – after all, that equates to an interest rate of 17.5% which is lower than some credit cards.

But here’s the catch: the term is usually only two weeks. That means if you don’t pay the money back in 15 days, you get charged another 17.5%. Then, if you still haven’t paid off the loan after 30 days, you’ll be charged – you guessed it – another 17.5%.

So what happens if you’re not able to pay the loan back immediately?

You might quickly find yourself underneath a mountain of debt. Let’s say, as an example, you need to borrow $500 to pay for repairs on your car, so you get a payday loan. However, it turns out that it takes you four months to save enough money to pay back the loan. During that time, the loan rolls over 8 times, meaning you get charged 17.5% interest eight times on the original $500 loan. Here’s what your interest would look like:

$500 x 17.5% x 8 terms = $700

That represents a whopping 140% interest over the 8 terms! In terms of APR, this ends up equating to about 455%. Yowza! Compared to other forms of short-term borrowing, that is abominably high. Even a credit card with insanely high interest rates has an APR of no more than 40%. This chart (w/ data from the CFA) shows expected interest rates for four types of short-term loans:

 

Type of Credit Finance Charge APR Total Paid
Small Loan $38.04 36.00% $538.04
Credit Card Cash Advance (Average) $48.86 29.10% $548.86
Credit Card Cash Advance (Higher Cost) $66.77 39.28% $566.77
Payday Loan $700 455% $1,200

 

As you can see, the payday loan dwarfs the other four types in total cost. Which is why we can pretty easily conclude that payday loans are predatory. So borrowing from payday loans is more than 10 times as bad for your finances as borrowing cash from your credit card company. A 455% interest rate over four months is unreasonable.

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