Understanding The Payday Loan

[May 31, 2008.]

 

If you are in a tight financial situation, you may be tempted by all those sings along the large boulevards in your town, advertising “easy payday loans.” However, payday loans are best avoided. Their exorbitant interest rates on these loans may entrap you into a never-ending cycle of repayments, or worse - if find yourself unable to pay off the loans with their high interest, the lender may sue you. You might find yourself in court, facing bankruptcy, and with your credit ruined.

What is a payday loan? The Federal Deposit Insurance Corporation defines a payday loan as any short-duration, unsecured loan, usually for an amount between $100 to $1,000, which the person who takes out the loan pledges to repay with the next paycheck they get.

To repay the loan, the person must pay the amount of the loan, plus a “finance charge.” Usually the finance charge is something like $20 per $100 borrowed for the loan. Unfortunately, many payday loan borrowers don't realize that this “finance charge,” in fact, represents the interest on the loan.

When the term of the loan is over, you can either pay the amount of the loan, plus the finance charge back in full - or, you can pay just the finance charge to defer the loan for another term. That's when the payday loans exorbitant interest rate starts to really hurt the buyer.

For example, a finance charge of $17.50 on a loan of $100, will grow to a finance charge of $105 if the loan held over for even one term. That adds up to a compound interest rate of 426%. Even credit cards, also notorious for their interest rates, do not charge this much. The annual compound interest rate for a $300 cash advance on the average credit card would usually only amount to about 57%, which is still very high.

If you don't pay off a payday loan right away, you may end up like one woman who spent $7,000 paying off a loan of $1,000 over the course of many months. That's $6,000 in interest, or, in other words, an interest rate of 600%.

So, why do people take out payday loans, if they are so disadvantageous? The answer is that payday loans aren't generally offered by mainstream lenders and financial institutions such as banks. Payday loans are typically offered by small payday loan stores, pawn shops, check cashing stores, or by hard-to-trace companies on the Internet. These businesses give customers their money fast, and require very little of customers before giving them the loan. All a customer needs is a functioning bank account, identification papers, and a documentation of income. Thus, payday loans entice people who are in desperate need of money, who want to borrow money quickly without thinking very much about the consequences.

Unfortunately, the smaller businesses that traffic in payday loans are much more loosely regulated than big institutions such as banks and brokers. This makes it easier for the payday-lending institutions to take advantage of consumers. Indeed, payday lending is seen as so questionable that only 37 out of 50 states even allow it.