Payday Lenders and Loans

Illustration of Payday loans and lendersWant to guess at a community’s financial health? Abandoned houses or vacant shopping centers are an obvious sign things aren’t good, but a more subtle indication of financial insecurity is the number of payday lenders in the area — businesses that cater to cash-strapped customers willing to pay exorbitant interest for small personal loans.

According to a 2015 study by the Pew Charitable Trusts, 12 million Americans take out payday loans each year and spend $7 billion on loan fees. Though the interest rates commonly are disguised as fees, they effectively range from 300%-500% annual percentage rate (APR).

Compare that the 15%-30% APR on credit cards or 10%-25% rate for a personal loan from a bank or credit union and it’s hard to see why anyone would go this route.

According to Pew, the typical payday loan customers are mainstream workers, those earning at least $30,000 a year. Payday lenders target financially strapped customers who don’t qualify for credit cards or have very low credit limits, mostly due to past financial problems. While people with conventional credit cards can use their borrowing capacity to cover short-term needs, those without credit often have nowhere to turn. They might use a payday loan to cover rent and avoid eviction or utility bill to avoid cut off, but the huge interest payments usually leave them in worse shape.

What Is a Payday Loan?

Payday loans are unsecured cash advances for small amounts of money (usually less than $1,000) with very high interest rates and short-term repayment demands. A typical loan $500, which borrowers often need to cover essentials such as rent, utilities, food or a medical bill. Though the name suggests loans are linked to a borrower’s paycheck, lenders will sometimes issue loans if they are certain the borrower will have access to repayment cash soon.

In the United States, payday loan operators typically operate from storefronts in low-income neighborhoods. Their customers generally have poor credit and have no other access to money to cover urgent bills. Payday lenders use different methods for calculating interest rates, often demanding nearly 400% on an annualized basis.

Though many people assume payday lenders charge high interest because they deal with high-risk customers, default rates are typically quite low. Many states now regulate payday loan interest rates, and many lenders have withdrawn from states that do.

Banks Could Be Making Small Loans

In spring 2018, the federal Office of the Comptroller of the Currency, which regulates national banks, announced that banks would be able to write loans smaller than $5,000 and not be subject to standard underwriting rules. The goal is to expend bank lending to people whose credit makes it impossible to qualify for conventional loans or credit cards.

Banks used to make those sorts of loans, called deposit advances, which were generally repaid quickly – often before a borrower’s next paycheck. But new banking rules ended the practice in 2014 after regulators warned that deposit advances sometimes led borrowers to crippling debt. The 2018 revision will allow banks to return to the business, but perhaps not for long. The CFPB is scheduled to impose strict regulations on loans of 45 days or less.

However, in June of 2018, the bureau’s acting director said he would like to reevaluate that rule.

Who Uses Payday Loans?

According to the Community Financial Services Association of America, there are an estimated 18,600 payday advance locations nationwide that have extended $38.5 billion in credit to 19 million households.

The simplicity of borrowing and the easy access to cash make payday lending appealing to many consumers, mostly those who have little or no access to conventional credit.

Payday lenders rely on repeat customers, often low-income minorities, charging exorbitant compounding interest for cash advances. They seldom offer borrowers workable repayment plans, and in many states, operate with few regulations.

Payday lenders advertise on TV, radio, online and through the mail, targeting working people who can’t quite get by paycheck to paycheck. Though the loans are advertised as helpful for unexpected emergencies, seven out of 10 borrowers use them for regular, recurring expenses such as rent and utilities.

Payday lenders offer cash-advance loans, check-advance loans, post-dated check loans or deferred-deposit loans. They almost never check credit histories, making their loans easy to get, but interest rates are extremely high, and customers are among the nation’s least savvy borrowers.

The Consumer Financial Protection Bureau (CFPB), a federal government agency, issued a report in 2014 that showed most payday loans are made to borrowers who renew their loans so many times they end up paying more in fees than the amount they originally borrowed. The average payday loan borrower spends $520 in fees for what originally was a $375 loan.

Despite the well documented consumer hazards, the U.S. payday loan business thrives in states that don’t put caps on interest rates. In 2008, a Dartmouth economist said there were more payday loan outlets than McDonald’s restaurants and Starbuck’s coffee shops combined. But there are signs the business is in retreat as an increasing number of states have imposed rate caps. The Pew study said the number of states where payday loan lenders have operations, dropped from 44 in 2004 to 36 in 2015.

The decline in operations has cut deeply into the payday loan business. The nonprofit Center for Financial Services reported a steep decline in the storefront loan business that began in 2013, with revenue falling 23.4% from 2014 to 2015 alone. Revenue also fell by 22.5% for nonbank online payday loans in the same period.

But as payday loan revenue declines, issuers of subprime credit cards have made big gains, keeping the level of all subprime consumer lending relatively constant in the past several years.

How Do Payday Loans Work?

Getting a payday loan can be deceptively easy. You simply walk into a store with a pay stub, ID such as a driver’s license and a blank check from your checkbook. The stores often double as pawn shops. The clerk will offer a small amount, typically $100 to $500, that is due when you’re paid next. You will commit to paying what might sound like a reasonable amount – say $15 for every $100 borrowed.

The lender will demand you make out a postdated check to cover the loan plus fee and tell you that the check will be cashed at the end of the loan period, usually two weeks. Sometimes they will ask you to provide an authorization to electronically withdraw money from your bank account. When the due date arrives, cash-strapped people quickly discover that they need every dollar from their next paycheck to cover living expenses, so they return to the lender and ask for a repayment extension. This can add up quickly.

Payday lenders are subject to the federal Truth in Lending Act. It requires that lenders disclose the cost of the loan. Payday lenders must disclose the finance charge and the annual interest percentage rate (APR) in writing before you sign for the loan.

Though payday lenders commonly operate out of storefronts, a newer class of loan operator uses the internet. Some offer loans directly, others are information brokers that ask questions and sell what they gather to lenders. Financial experts say online lenders can be risky. They might offer a loan, but you can’t be sure if they will use your information for other purposes, potentially opening the door to scam artists. Many of the online sites are information brokers, which gather your financial data and sell it to lenders.

Cost of Payday Loans

Borrowing costs can soar astronomically in a short amount of time. Cash-strapped borrowers will often return to the lender saying that they don’t have the money to repay the loan, something lenders actually like to hear. They will offer an extension, known as a roll over, that will give you another two weeks to repay the loan with the caveat that you must pay another fee.

After the first roll over, you will owe $30 in addition to the $100 you borrowed. After six months, the fees will hit $180 plus the principal, leaving you with a debt of $280. Borrowers can easily get caught in a debt cycle, taking out additional payday loans to repay old ones, all the time sinking deeper into financial quicksand.

Payday lenders’ prime customers have long been poor people and military personnel. Payday lenders used to set up shop just beyond the perimeter of military bases, gouging soldiers and their families. To stop the practice, a 2007 federal law capped annualized payday-loan interest at 36% for active-duty service personnel and their families. Not surprisingly, the lenders are moving elsewhere.

Reasons to Avoid Payday Loans

Think before you borrow, remembering the financial pitfall implicit in payday borrowing:
  • Payday Loans Are Very Expensive – High interest credit cards might charge borrowers an APR of 28 to 36%, but the average payday loan’s APR is commonly 398%.
  • Payday Loans Are Financial Quicksand – Many borrowers are unable to repay the loan in the typical two-week repayment period. When it is due, they must borrow or pay another round in fees, sinking them deeper and deeper into debt.
  • Borrowing from Short-Term Lenders Is too Easy – Unlike bank loans and credit card accounts, payday loans don’t require extensive paperwork. You can get one just by walking into a store, signing some papers and writing a check. And unlike other loans, once you sign the papers and take the money, you can’t change your mind since the loans commonly don’t contain a right of recession.
  • Some Payday Lenders Want the Right to Access Your Bank Account – They say it will save you the hassle of writing the commonly used post-dated check. But if the loan comes due and the funds aren’t in your account, the payday lender can make repeated attempts to withdraw the money, often resulting in multiple overdraft charges of $35 or more.
  • Payday Lenders Can Be Ruthless Debt Collectors – If you can’t repay the loan, prepare for a barrage of tactics that includes late-night calls from debt collectors.

Payday Loans Can Ruin Your Credit

Payday loans can be very tempting, especially to those without cash reserves and less-than-sterling credit histories. But beware, just because a payday lender doesn’t seem to care about your credit worthiness doesn’t mean borrowing the money isn’t perilous.

If you can’t repay the loan on time and fail to get a roll over from the lender, you could have an immediate problem. Since lenders usually demand a postdated check before issuing the loan, the check will be deposited on your next payday. If the check bounces, you go into default and could enter debt-collection hell.

The payday lender will first try to collect the debt. It might try repeatedly to deposit your check or try to withdraw money incrementally from your bank account. Each failed attempt will likely add bank charges to your account.

If trying to withdraw money is unsuccessful, or you close your checking account, the lender might try calling you at inconvenient times, having a law firm send you letters and calling friends and relatives.

More failed efforts might prompt the lender to propose a settlement for a lesser amount. Since you what owe includes exorbitant interest, a lender might not suffer a loss in a settlement agreement.

If all else fails, the lender likely will refer your case to a collection agency, which will first try bombarding you with phone calls. Later they might even take you to court, which can end up in the public records portion of your credit report if a judge rules in the lender’s favor. If any of these things happen, your credit rating can be seriously damaged, making it even harder to get credit. Even if your credit wasn’t good before the payday loan default, a fresh collection action will almost certainly make it worse.

Rather than torpedoing your credit score, notify the lender immediately if you know your loan check will bounce and request a payment plan. This might mean higher fees and make the loan harder to repay, but that trumps major credit problems.

Other options include borrowing the money needed to repay the loan from friends or family, or freeing funds by postponing payment on a less pressing debt. If you have a credit card, consider other options like taking a cash advance to make the payment. You could write a check on an account with overdraft protection. The overdraft might result in a bank charge, but if you can raise the money to cover the bank charge, it might be preferable to tangling with collection-minded payday lender.

Payday Lenders Prey on the Poor

Payday loans are offered at payday loan stores, check-cashing places, pawn shops and some banks. Payday loan stores are open longer than typical bank hours, giving you easy access to cash regardless of the time of day.

Payday lenders require borrowers to write a check for the amount of a loan plus a fee, which the lender holds. The lender agrees not to deposit the check until the borrower has received his or her next paycheck. Since most people receive biweekly paychecks, the typical loan period is two weeks or less.

Once the next paycheck comes in, the borrower may choose to let the check go through, return to the lender and pay in cash, or pay more to allow the loan to roll over. Payday lenders charge fees for bounced checks and can even sue borrowers for writing bad checks.

The process allows those who have little or no credit to quickly access cash. Payday lenders do not check borrowers’ credit scores, nor do they report borrowers’ activity to credit bureaus.

Lenders require borrowers to earn at least $1,000 a month and to provide the following:
  • Home address
  • Valid checking account number
  • Driver’s license
  • Social Security number
  • A couple of pay stubs to verify employment, wages and pay dates

Payday lenders often seek out locations in impoverished and minority neighborhoods.

A typical borrower has one or more of the following characteristics:
  • Young age
  • Has children
  • High school graduate
  • Does not own his or her home
  • Relies on Social Security checks
  • No access to any other type of credit

Nearly everyone who visits a payday lender has been there before. It is unusual for a customer to go to a store, repay the loan and accompanying fee and never return. One-time customers account for just 2% of payday loan business.

An estimated 90% of borrowers take five or more loans a year, with an average of nine. Each loan comes with an initial fee, which is compounded every time the loan rolls over.

The Credit Research Center at Georgetown University’s McDonough School of Business notes these common characteristics of payday customers:
  • Limited credit availability
  • Borrowed from a pawn shop in the last five years
  • Filed for bankruptcy protection within five years
  • Made late payments on mortgage or consumer debt in the last year

Payday lenders also target military personnel. One in five active-duty soldiers was a payday borrower in 2005. But since 2007, the Department of Defense has prevented lenders from requiring a check from borrowers, and the annual percentage rate for military borrowers has been capped at 36%.

Some states require payday lenders to be at least a quarter of a mile from each other and 500 feet from homes — similar to the restrictions on sexually oriented businesses.

Alternatives to Payday Loans

Though payday loan borrowers generally don’t think they can borrow money anywhere else, there are alternatives they should consider. Among them:
  • Credit Unions and Small Loan Companies – Credit unions are a very good place to start looking for a small loan. Joining one has been made considerably easier and members serve as owners so they can be more lenient about qualification standards for loans. Some local lenders might be willing to loan small amounts at competitive rates, especially to businesses. Credit-card cash advances are another option. Though the interest rates are in the double digits, they are often considerably less than those available from payday lenders.
  • Shop Before You Decide – Compare APRs and finance charges from all available sources. Alternative lenders might charge high rates, but might not impose the high loan rollover fees that payday lenders typically demand.
  • Protect Yourself – Contact creditors or loan servicers if you can’t make a payment on time. They might be willing to work with you, offering a payment plan that might obviate the need for a payday loan.
  • Get Credit Counseling – Non-profit agencies around the country offer credit advice at no or low cost to the borrower. To find a credit counseling agency, go online, talk to a credit union, housing authority manager or an employer’s personnel department for suggestions.
  • Develop A Budget – Create a balance sheet with cash inflows and outflows. Knowing how much you have coming in and where you’re spending it is crucial to managing personal finances. Next, consider eliminating any expenses that aren’t crucial. For instance, cable is a good place to start eliminating expenses. Look for another provider or drop to a cheaper package. Keep in mind that it is a serious mistake to borrow at high interest rates to pay regular monthly expenses. If you can’t pay the rent without a loan, move to a cheaper place.
  • Find Out If Your Checking Account Has Overdraft Protection – Protecting yourself against the credit damage that bounced checks cause is important. But it’s important to know what overdraft protection costs and what it covers.

Payday Lenders Promise a Debt Cycle

In order to avoid discussing their triple-digit interest rates, payday lenders commonly advertise what they call a price-per-$100 fee, which is typically $15 to $20 for every $100 borrowed. Each time the loan rolls over, commonly every two weeks, a new fee is added. At that pace, the amount owed on a $200 loan could soar to $500 in just 20 weeks. That’s an annual interest rate — what lenders call the annual percentage rate or APR — of 391%.

Computing the annual percentage rate (APR) for payday loans can be done in a few simple steps:
  1. Divide the finance charge by the amount of the loan
  2. Multiply by 365 (number of days in a year)
  3. Divide by the term of the loan (typically 14 days)
  4. Move the decimal two places to the right and add the percent sign

Many customers using payday loans are unaware of the high interest rates and focus more on the so-called fees. The Truth in Lending Act of 2000 required the APR be released on payday loans. Focusing on the fee alone prevents customers from shopping around and comparing APRs that banks and credit unions may offer. The difference can be substantial.

The Pew study found the average payday loan was $300 and lasted five months. Borrowers paid $459 in fees for those loans. People who took out $300 loans for five months from banks or credit unions paid about $13 in fees. Many credit cards charge a cash advance fee of 4 or 5%, with a 25% annual interest rate, or about $35 in interest and fees.

The problem is many customers don’t believe they qualify for personal loans or have maxed out or closed out their credit card accounts.

Customers may use payday loans to cover emergencies like doctor’s visits or car problems, but most use the loans to cover utilities, rent or other recurring monthly bills. The difficulty occurs when the loan is due because by then it is time to pay the next month’s cycle of bills. In that case, users are forced to take out another loan to keep up with their regular bills.

The majority of payday borrowers function in this way, either paying a fee to roll over a loan for two more weeks or taking out new loans, immersing them into a dangerous cycle of debt.

Government Regulation

According to the Pew Charitable Trust study, 75% of Americans are in favor of more regulation of payday loans.

The CFPB came up with a series of proposals in 2015 requiring lenders to make sure consumers can repay the loans. The CFPB wants payday lenders to verify the consumer’s income, major financial obligations and borrowing history. There would be a 60-day “cooling off” period between loans. No more than three rollover loans would be permitted in a 12-month period.

Despite the industry’s giant footprint, it isn’t everywhere. Eleven states, as well as Washington, D.C., Puerto Rico and the Virgin Islands, either don’t allow payday lending or restrict it to conform with the interest rate caps placed on consumer loans. Thirty-eight other states have specific statutes pertaining to payday lenders.

In most jurisdictions that permit payday lending, loan maximums are enforced, typically ranging from $300 to $1,000. Statutes also set the duration for a loan term — some as short as 10 days — but other states place no restrictions on the duration of a loan. The laws also specify how finance charges can be assessed, and these vary widely. Alaska, for instance, sets a loan maximum of $500 with a two-week duration and sets a maximum fee of $15 per $100 loaned, or 15% of the loan amount, whichever is less.

The safest loans follow national credit union guidelines or limit payments to 5% of income, and limit loan duration to six months. These rules would provide a pathway for banks and credit unions to offer customers lower-cost installment loans.

Pew’s analysis of the initial proposal recommends a stronger ability-to-repay standard in the CFPB rule and clearer guidelines to prevent unreasonable loan durations, unaffordable payments, and lender abuse of checking account access.

Pew supports the CFPB’s clear standards that enable lower cost loans with affordable payments at 5% of a borrower’s monthly income and a reasonable term of up to six months.

Bill Fay

Bill Fay is a journalism veteran with a nearly four-decade career in reporting and writing for daily newspapers, magazines and public officials. His focus at Debt.org is on frugal living, veterans' finances, retirement and tax advice. Bill can be reached at bfay@debt.org.

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