Personal Finance

How Do Payday Loans Work?

payday-advance-post-dated-checks-cashed-1057118-639x935Payday loans have grown in popularity over the years. You’ve no doubt seen any number of television commercials or billboard advertisements selling nothing more than fast, easy money.

The pitch is pretty simple, anyone who has a cash emergency for an overdue bill payment, a car repair, or any other unexpected expense out of the blue (and who among us hasn’t experienced a similar snafu in the past?) can come to a payday loan company to get the money they need in a short period of time. Whether it’s fifteen minutes or one day, these companies sell the concept of quick money to consumers who have the need for it, sometimes without the hassles of a credit check.

The idea is that you can get an advance on the money that you are expected from your paycheck at the end of the week. You’re working and you’re going to get paid, but that could be days from now and you need the money NOW. Right now.

That’s where the payday lender comes in. These companies are all too happy to help you out with your little cash crunch. Just fill out the paperwork, tell them how much you need, and the funds can be in your account in no time at all.

Sounds pretty great, doesn’t it? Naturally there’s more to it. That’s where problems can arise for some consumers who don’t always take the time to read the fine print. Many of them don’t fully research who they’re dealing with and what they’re getting themselves into with a payday loan.

For some consumers a payday loan can be a useful alternative to getting the money they need in a pinch and have few other options. There are also horror stories from customers who ended up paying extremely high costs to borrow a small amount of money. The costs that come with these loans can sometimes become exponentially more than the original principle borrowed due to very high interest rates, far higher than you’d find at most banks or other traditional lenders.

The reason payday lenders charge so much more in interest is because many consumers who are applying for a payday loan may not be approved by the bank or don’t have the luxury of waiting out the time it would take to go through the process of a bank loan. You need this money now. The payday loan companies offer a fast service that eliminates all of that red tape…but you are going to have to pay for that convenience.

We all get jammed up from time to time and need a lifeline when friends and family can’t help and there’s no one else to turn to in our hour of dire financial need. A payday loan might be the best (and perhaps only) choice available to you. Before you take that step, however, be sure you know exactly what it is that you’re getting into and fully understand how payday loans work. This guide will help you navigate your way through the process and avoid some of the dangers that are inherent to borrowing money via this avenue.

The Payday Loan

These loans typically aren’t intended for borrowing large amounts of money over an extended period of time. They usually range for as little as $100 to as much as a few thousand dollars depending on the company you’re working with and, more importantly, the state in which you are conducting the transaction. The laws surrounding these types of loans vary greatly from state to state and certain areas have stringent limits on payday loans. Don’t worry – we’ll get to the regulatory aspect of these transactions in a bit.

The way a payday loan works is pretty straightforward. Let’s say you need $400 for an emergency and decide you’re going to go the payday loan route to get that money. First off, you need to have a checking account because you are going to write a personal check made out to the lender for the amount you need to borrow, in this case, it’s $400 in addition to whatever the fee happens to be through that company. These loans are expected to be paid off in one lump sum which is why you’re giving them a personal check.

The payday loan company then holds your check up until the agreed upon due date for the loan to be repaid. Most loans have a 14 day term, but it could be less or more based upon the company that you’re dealing with for your payday loan. You will then receive your money by the next business day.  Some companies even offer same day service, either by check or through electronic transfer directly into your account.

The Fees

Here is where the payday loan can pose some potential problems. Most loan companies charge fees that range about $10 to $30 for every $100 that you borrow. So using the example of that $400 you need to borrow immediately, you could pay anywhere from $40 to $120 in order to borrow that $400.

At those numbers you’re looking at a possible 195.5% interest rate. That’s on the low end of APR’s for these payday loans as some states permit a company to charge as high as 400% to 500% interest rates on borrowed money. These rates can fluctuate based on the term of the loan, with shorter terms sometimes coming with higher rates because you’re borrowing the money for less time. Again, this may vary depending upon your state.

If you really need this money and own a credit card, then you may as well take out a cash advance on a credit card as you’re going to pay far more with a payday loan than you would getting the money from your card issuer. The typical APR on a cash advance from your MasterCard or Visa is usually capped at around 30%. That is significantly less than 400% or even 195%. Unfortunately, not everyone has the luxury of turning to their credit card company for a cash advance and that the payday loan companies are aware of (and take advantage of) this fact.

Rollovers and Increased Debt

So you’ve borrowed that $400 with the full intention of paying it all back in the 14 day term with that check you handed over to the payday loan company. Unfortunately, it turns out you can’t pay the money back in full by the 14 days. Your paycheck just barely covered your bills, gas, and food and, since you can’t pay this loan off in installments (this is a lump sum repayment, remember), you need to borrow the money again for another 14 days.

The payday loan company is going to be all too happy to extend you another two weeks at the same rates all over again. So instead of $120 to borrow that original $400, it’s now going to cost you $240. They’re not giving you another $400, either.  You’re still paying off the original loan amount.

Then, what happens if you can’t pay it off after that second 14-day term? You guessed it – the payday loan company will extend you another 14 days at another $120 and now you’re going to end up paying $360…on a $400 loan!

These rollovers are where the payday loan companies can really make a lot of profit off of their customers. They understand that not everyone is going to need to rollover their loan two, three, maybe four times over. However, since most consumers who take out payday loans are already dealing with financial issues that preclude them from having $200, $300, even that $400 you borrowed in the example we’ve been referring to thus far, paying the loan back could be challenge.  That’s how many consumers become trapped in a never-ending cycle of mounting debt.

Just think about it. You had a money emergency that required you to borrow $400 and now you’re possibly in the hole for $360, on top of the $400 you needed to borrow. If you manage to pay the loan off after that third extension, it could ultimately end up costing you $760 in total by the time it’s all said and done.

empty-pocket-1-1536707-639x549Bounced Checks

The potentially high fees for borrowing money from a payday loan don’t even factor in the possibility of the fees that you can incur from a bounced check. When you take out a payday loan you’re giving the company a check from your account that doesn’t have sufficient funds to cover that check when it is presented for deposit on the repayment due date.

If the check bounces then you’re going to get hit with an NSF (non-sufficient funds) fee that typically runs about $30 at most of the major banks. That’s on top of the fee the payday loan company will charge you for a returned check. That could easily be another $20 to $30. So now you’ve racked up $60 in fees just for bouncing the check and you’re going to need to rollover the loan for another 14 days, and we’ve just seen what that could cost you.

You may think about putting a stop payment on the check before it’s due to be deposited in order to avoid those fees. Think again.

Most banks will charge you a fee for a stop payment. That fee is less than a NSF fee, but not by much, ranging from $15-$30 depending on your bank.  Plus, the payday loan company may still charge you the returned check fee anyway. In addition, stop payment orders end after about six months in most cases and that means the payday loan company could present the check for payment after that time, if they are still rightfully owed the money.

Repaying in Installments

Although payday loans are intended to be loans that are paid back in one lump sum on a short term basis, consumers may face challenges in trying to repay their loans.  In this case they could face significantly larger fees and extended periods of repayment time. If a consumer finds him or herself in this hole, a number of states have legislation in place that mandates payday loan lenders to offer installment plans for paying back the money that has been borrowed. There are only eight states that require the companies to offer this alternative: Alabama, Alaska, Florida, Illinois, Michigan, Nevada, Oklahoma and Washington.

In some cases, the payday loan company has the right to garnish wages directly from your paycheck in order to pay back your loan. This language may be in the original loan agreement that you signed. If you didn’t read the legalese in full (and honest, who reads all of that fine print?), then you could be faced with a voluntary wage assignment which gives the company the right to dip into your account for reimbursement.

Not all companies have this clause in their agreements as it is prohibited under the Federal Trade Commission’s Credit Practices Rule.  Nonetheless, but be sure to read the fine print carefully.  If you realize you are stuck with this clause in your agreement after the fact, then write a letter rescinding this permission without a court order being obtained by the payday loan company first.

Is All of This Legal?

Five hundred percent interest rates, wage garnishments, fees on top of more fees…is all of this even legal? For the most part, yes, the payday companies have the legal right to charge these incredibly high rates on short term loans. However, there are explicit regulations in place in many parts of the country capping how much a lender give out per transaction and the interest rates attached to borrowing that money.

Some states even put a maximum limit on the number of loans a consumer can take out, limit the amount of renewals on a loan, and as stated earlier, provide mandates for lenders to offer installation plans for reimbursement of a loan in full. Due to the recent controversies surrounding the high costs of these loans and the attention the payday loan industry has garnered as a result, a number of additional regulations have been put in place in certain jurisdictions.

There are currently 18 states and the District of Columbia with laws on the books that limit or prohibit entirely the use of high cost payday loans. The state of Georgia has outlawed the practice entirely claiming payday lenders violate racketeering and New York and New Jersey have also prohibited payday loans because they are in violation of state usury laws. As a result, both states have placed a cap on the interest rates that the lenders can charge. For New York it’s capped at 25% and New Jersey has a maximum of 30% interest annually.

Arkansas has had a long history with payday lenders when the state Supreme Court found that legislation on the books called the Check Cashers Act which authorized payday lenders to operate in the state unfettered was actually violating state usury caps in 2008. Two years later in 2010, voters were in favor of placing a 17% annual rate cap on these types of loans and the following year the Check Cashers Act was repealed entirely.

The states of Arizona, Connecticut, Maryland, Massachusetts, North Carolina, Pennsylvania, Vermont, West Virginia, and the District of Columbia have put loan rate caps on payday loan transactions and the practice of payday lending isn’t officially authorized within their borders. Only Arizona, North Carolina, and the District of Columbia have repealed any payday lender authorizations that were on the books at any point.

Maine, Oregon, New Hampshire, Ohio, and Montana allow for payday lenders to conduct business where loans are provided in return for checks that are held on deposit. The rates here are significantly lower than in most other states, yet the companies can still charge rates well above the norm from other financial entities.

Residents in the state of Montana voted in a measure to cap rates on small loans from payday lenders at 36% as of 2011. In Ohio, legislation was passed in 2008 to put a 28% ceiling on small loan rates and defeating a ballot initiative to bring that maximum back to 390% annually, an APR that was the norm prior to the vote. New Hampshire has a cap set at 36% since 2009. The state of Oregon allows for a one-month minimum term payday loan with 36% interest and an upfront fee of $10 for every $100 that is borrowed while Maine puts a cap on payday lenders at 30% but allows for tiered fees that can get as high as 261% APR for standard $250 loan on a 14 day term.

The state of Colorado has taken additional measures to modify the laws governing payday loans. As of 2010, new legislation placed a minimum of six months for loans using a personal check to borrow money from a payday lender. Now such loans may come with a barrage of fees and charges that include up to 45 percent interest, maintenance fees of 7.5% per month, tiered finance charges that come with 20% for up to the initial $300 lent out and 7.5% for any amount between $301 and $500 after that. Loans may also be paid back at any time and do not require them to be paid in full in one lump sum, although doing so is permitted. Colorado requires payday lenders to allow for installment plans.

The remaining 32 states allow payday lenders to operate without much of any major regulations in place prohibiting exceedingly high interest rates in transactions where a personal check is handed over to complete a small loan transaction. These parts of the country still have various maximum loan amounts and terms and conditions in place affecting the amount of money and length of term, repayment options and number of outstanding loan transactions allowed per consumer.

However, these vary from state to state. These states are: Alabama, Alaska, California, Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Michigan, Minnesota, Mississippi, Missouri, Nebraska, Nevada, New Mexico, North Dakota, Oklahoma, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia, Washington, Wisconsin, and Wyoming.

payday-loan-seach-boxOur Final Thoughts

Payday loans are not for everyone, yet anyone who decides to pursue one should be sure they are able to pay it back by the end of the term. As we’ve discussed, that is typically anywhere from 7 to 14 days. If you are unable to pay the loan back, you will incur a litany of high fees on top of those you are already committed to paying once you’ve borrowed the money. Since some of these rates can get well into the range of thousands of dollars, you don’t want to be caught having to continue paying those sky-high fees in the event you are unable to make good on the reimbursement.

For those who are considering taking out a payday loan you may want to think about some of the alternatives that exist before you pull the trigger. Many credit unions and banks offers similar short-term loans at the same funding levels as payday loans, but for far more affordable rates. We’ve also made comparisons between payday loans and getting a cash advance from your credit card company. That is also a viable alternative for many consumers that should also be explored in full first.

There also a number of local community-based groups that provide small business loans should the money you need qualify as such. All of these are viable options that you might be able to rely on instead of facing triple-digit interest rates and additional fees should you be unable to pay the money back on time.

After you’ve exhausted all of those other options, if you still need to take out a payday loan be sure to shop around and find a loan offer with the lowest prices and fees. There are plenty of payday loan companies out there now, most of them with an online presence that allows you to apply for money through a website. Do some comparison shopping to track down the lowest APR and other costs associated with completing the transaction. Taking the time to find the right lender may save you a considerable amount of money in the long run.

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