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Payday Loans: What to Know and What to Avoid

Reading time: 3 minutes

If you’ve ever been short on money and far from your next paycheck, you may have considered a payday loan. These short-term cash loans are based on the income you’ll receive from your next paycheck. In other words, you’re borrowing from your own future income rather than a third-party funding source.

Payday loans are risky options for borrowers. For starters, they have incredibly high interest rates—as much as 400 percent on an annual basis. If you were already living paycheck to paycheck, it may be extremely difficult to pay back the loan and still cover your monthly expenses, especially with your income reduced by the amount you borrowed. However, if you’re one of the 40 percent of Americans who can’t afford an unexpected expense of $400, a payday loan might feel like your only option.

Payday loans are made by either specialized payday lenders or more general lenders that sell other financial services. You can easily find them via brick-and-mortar stores or online. Most payday lenders just need a borrower to meet the following conditions in order to offer you a loan:

  • Have an active checking account
  • Show proof of income
  • Provide valid identification
  • Be at least 18 years of age

Payday lenders won’t usually run a full credit check or ask questions to determine if you can actually pay back the loan. Loans are made based on the lender’s ability to collect, not your ability to pay, so they can frequently create a debt trap that’s nearly impossible to escape.

Because the interest rate on a payday loan can be astronomical, it’s important to be sure you can pay back the debt in a timely manner.

For example, let’s take what seems like a simple $400 payday loan with a two-week term. A typical fee for every $100 lent is $15. So in two short weeks, you’d have to pay back the $400 you borrowed, plus a $60 fee. Depending on your financial situation, that might be difficult to do. The Consumer Financial Protection Bureau (CFPB) says that in states that don’t ban or limit loan renewals or rollovers, the payday lender may encourage you to pay just the fee and extend the loan another two weeks. If you accept — or feel like you have no choice — you’d pay the $60 fee and still owe $460 when the extension is over. That would mean you’re spending $120 to borrow $400 for one month.

The CFPB recommends against taking out a payday loan, suggesting instead that you take the time to fully evaluate and exhaust all available options:

  • Renegotiate with your current lenders: If you’re struggling with significant debt, whether from credit cards, student loans or another source, reach out to your creditors and explain your situation. Many lenders are willing to work with you to establish a monthly payment plan that can help free up some needed income each month.
  • Ask your employer for an advance: This follows the same basic principle as a payday loan in that you’re borrowing money against yourself but without the risk of additional interest. Your employer might reject your request, but it’s worth a shot if it means you can avoid paying exorbitant fees and interest to a payday lender.
  • Ask a friend or family member to lend you the money: Asking a loved one for help might be a difficult conversation, but it’s well worth it if you’re able to avoid the outrageous interest that comes with a payday loan.

If you decide to take out a payday loan, go into it well aware of the risks. Ask your lender a lot of questions and be clear on the terms. Strategize a repayment plan so you can pay off the loan in a timely manner and avoid becoming overwhelmed by the added expense. If you understand what you’re getting into and what you need to do to get out of it, you’ll pay off your loan more quickly and minimize the impact of outrageous interest rates and fees.

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