Payday lenders offer small loans designed to help tide you over to the next paycheck. These loans are set up to be paid back by the next paycheck, but many low-income borrowers need the funds for the next paycheck to pay their bills, and end up taking out another payday loan.
Payday loans have very high interest rates – as much as 400 percent on an average annual percentage rate, according to the Consumer Financial Protection Bureau. The lender may also charge administrative and loan fees, adding to the cost of the payday loan.
The average payday loan borrower ends up in debt for more than six months with an average of nine payday loan transactions, according to the Center for Responsible Lending. More than 12 million Americans every year take out at least one payday loan.
How payday loans work
Many people end up with a payday loan due to a relatively minor financial emergency, such as a car repair or a medical bill.
The high interest rates on a payday loan make it very difficult for borrowers to repay the loan when it comes due– at the next paycheck – so they end up borrowing more money and getting more deeply in debt, setting up a cycle of debt that is very difficult to break.
The fees and interest rates charged as part of the payday loan are deducted from the amount received by the borrower, but the full amount is due on the borrower's next payday.
For a low income borrower, it can be very difficult to not only repay the loan and the fees from the loan, but also to have enough money to pay the upcoming bills that would be covered by the next paycheck, which now has to be used to repay the payday loan.
That's why many borrowers end up having to take out another loan and pay even more in interest and fees.
The costs of payday lending
For example, if you took a $350 payday loan, that loan typically would include $60 in fees. So you would receive $290 instead of the $350 because the fees are deducted from the loan.
If you can't repay the $350 loan when it is due – in a week or two when you next get paid – you would either need to pay another $60 in interest and fees to keep that loan outstanding or take out another $350 payday loan with $60 in fees.
That cycle can easily continue, with you paying $60 in fees every week or every other week because you can't pay the original $350 back.
If it took you six weeks to pay that amount back, and you were then able to stop from taking out another payday loan, that would be $360 in fees to borrow $350. You would pay more in fees than you actually borrowed.
And if the loan went on longer because you couldn't afford to pay it off, those fees would grow. If you kept rolling over the loan for 10 weeks, you would end up paying $600 in fees.
Alternatives to payday loans
There are alternatives to payday loans if you are in a financial crunch. Many credit unions offer small emergency loans at interest rates much lower than payday lenders. Some banks also have similar programs. You may also be able to get a cash advance from a credit card. While those interest rates may be high, they are not as high as that of a payday loan. Or perhaps you could borrow money from a family member or friend.
If your problem is that you are in too much debt or overwhelmed by bills, credit counseling can help. An accredited non-profit credit counselor can help you work out a payment plan with your creditors to get you on a sustainable financial footing.
Dive deeper: Payday loans: What you need to know
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
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