For those living paycheck to paycheck, a payday loan may feel like a port in the storm when cash is needed in a hurry, especially in these distressed times. But this type of debt often creates bigger financial problems for the borrower.
Such short-term loans are essentially a cash advance against the borrower’s next paycheck, typically due in two weeks when they receive their next paycheck, or some other source of income, such as a pension or Social Security check. All you need to secure a payday loan, in states where they are available, is proof of income and a checking account.
Some 12 million cash-strapped Americans use payday loans every year, said Alex Horowitz, senior research officer at The Pew Charitable Trusts, who advocates for more affordable small-loan options.
Who uses payday loans the most?
The majority of borrowers who use payday loans are low-income individuals in urban areas and the Midwest making less than $40,000 per year who fell behind on their monthly expenses, including rent, utility bills, or car payments, according to the Center for American Progress. They include populations that have historically been most vulnerable — the those without a college degree, renters, and people who are either separated or divorced. A growing number of payday loan borrowers are young people between age 18 and 24. 1 Individuals on federal disability are also more likely to rely on payday loans, according to the Center for Retirement Research at Boston College.2
Because of the exorbitant fees that payday lenders charge, the borrower becomes trapped in a cycle of debt.
“The average payday loan is $375, but the average borrower ends up having it out for five months of the year, which ends up costing them an average of $520 in fees on top of the $375 they originally borrowed,” said Horowitz.
According to the CFPB, most states that permit payday loans limit the amount that lenders may charge for fees to anywhere from $10 to $30 for every $100 borrowed. Thus, a typical two-week payday loan with a $15 per $100 fee equates to an annual percentage rate of nearly 400 percent.
By comparison, the agency notes that the annual percentage rate on credit cards typically ranges from 12 to 30 percent. (Related: Handling credit card debt)
“Most consumers can’t afford to pay back all of the money they owe by their next paycheck,” the CFPB reports in an online consumer alert video. “Within a month, almost 70 percent of borrowers take out a second payday loan.”
In fact, it found that 1 in 5 borrowers who take out a payday loan end up taking 10 or more payday loans in succession before they find the means to repay their debt, incurring more fees and interest on the same debt with each new loan.
“Payday loans are the most expensive credit available,” said Laurie Madenfort, a financial professional with Coastal Wealth in Fort Lauderdale, Florida, in an interview, who urged cash-strapped consumers to consider alternatives.
Alternatives to payday loans
Historically, traditional banks did not provide small-dollar loans because they were not commercially viable and because the regulatory framework for issuing such loans was not clearly defined. But in May 2020, federal banking regulators issued long-sought guidance that cleared the path for banks and credit unions to begin offering smaller loans that are cost-effective for both borrower and lender. Unlike payday lenders, banks report payment history to the credit bureaus, which allows borrowers who pay on time to improve their credit score.
“If banks offer small installment loans, that would enable consumers to borrow at a price point that is going to be six to eight times lower than a payday loan,” said Horowitz. “This would be very good news.”
Many banks are still rolling out their small-dollar-loan program, however. Until they’re available in communities nationwide, Madenfort suggests those in need of financial relief consider contacting their creditors to request an extension or work out a repayment plan. (Learn more: Setting financial goals: Debt)
Food assistance programs, which can help free up income for paying the bills, are also available for those in need of immediate food aid, and on a regular basis for seniors and school-age children, among others. Local food pantries, religious organizations, and nonprofit outreach groups in communities across America are also a free food source for those in need.
They can also potentially borrow from friends or family, consolidate debt to a lower interest loan, or contact government programs and nonprofit groups that offer assistance to families in financial need, said Madenfort.
“Consumers should start by contacting their county or municipality,” she said. “Most people don’t realize that there are resources available right where they work and live.”
On a federal level, the government has multiple programs as well, to help those struggling to pay for phone, utility, and medical bills, among other expenses.
Under certain circumstances, you could also have your federal student loans forgiven, canceled, or discharged.
Veterans who need assistance may also qualify for any number of programs available.
Before you take out a payday loan, consider the costs involved and always explore alternatives that can help you save money and get back on your feet faster.
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This story was first published in June 2016. It has been updated.