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Wednesday, May 09, 2007

Payday Loans

Recently, I have been seeing and reading a lot of ads and articles regarding payday loans or cash advances. In the past, every once in a while I would see signs at some small mom and pop store offering such loans but in the recent years, it seems like a lot of firms, including online firms, banks and credit unions have jumped into this field. Reason - a chance to earn high interest rates on short-term loan.

So what exactly are payday loans or cash advances? Payday loans are loans for small amounts, generally in the range of $100 to $2,000 for small period of time such as from 7 days to 2-3 weeks. Firms offering payday loans call it so because the purpose of such loans is to meet some financial need while a person is waiting to receive his/her next paycheck. These loans are also sometimes referred to as payday advances, fast loans, check advance loans, fast cash, etc.

Cash advance firms lend borrowers money generally based on their current salary although they may also look at their credit scores, etc. These cash advance firms generally give borrower the amount of loan, and in return, the borrower issues the lending firm a check for the amount borrowed plus a fee. For example, assuming a person borrows $200 for a two-week loan, and the fee is $20, the borrower will issue a check for $220 to the lending firm which will hold it until the next payday.

The fee charged may be based on a percentage of the face value of the amount borrowed (such as 15% of the amount borrowed), or a fixed amount based on the loan amount (such as $10 for every $100 borrowed). Depending on the agreed-upon plan, the cash advance firm may deposit the check on the next payday, or the borrower may pay back $220 in cash, or extend the loan for another couple of weeks by paying appropriate fee for extending the loan.

The issue with payday loans is that the interest rates charged on such loans are very high. For instance, in the above example, it is $20 interest on a loan $200. $20 by itself seems small but considering that the loan is just for a two-week period, this equates to an APR of about 261%.

Not surprisingly, such loans should be avoided when possible. However, if it is indeed absolutely necessary for me to get payday loans, some of the things I would consider include:

- Borrow only what I can afford to pay back on my next paycheck, including any fees/interest charges that I need to pay back, while still having money left over to make it till the next paycheck.

- The longer the period for which I borrow money, the more is the interest amount. So I would attempt to avoid rolling over the loan because that would mean paying additional fees/interest charges. It is better to keep the loan duration short to minimize interest charges.

- Compare the cost of payday loan with cost of borrowing from other sources such as banks, credit cards, etc. However, borrowing from sources such as credit cards may not always be cheap, especially considering that credit card firms can tack on late payment fee of $30 or higher, cash advance fees and other transaction fees in addition to high interest rates. Similarly, banks may charge loan origination and other fees. All these fees when added together can sometimes be way more than the fees on payday loans. So it is important to include all fees when comparing alternatives.

- As payday loans are a form of credit, the Truth in Lending Act requires lenders to disclose the cost of payday loans in writing, including the dollar amount of finance charges and the annual percentage rate or APR. It is important to go through these disclosures as they provide an indication of how much interest charges are being levied as well as other important information related to loan terms such as any prepayment penalties, etc.

- Above all, I would avoid making it a habit of getting payday loans as they can be very risky and can potentially cause a borrower to go deeper into debt. Such loans can provide relief in times of financial needs and emergencies but those should be genuine emergencies such as where a person may have lost his wallet, or needs to pay utility bill immediately. However, emergency needs should not be defined as the need to go on vacations, buy an expensive item, etc.

The best thing to do is to plan for emergencies by setting up emergency funds, so that there is no need to borrow money in the first place.

posted by Ruby @ 7:22 AM

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