In the world of personal finance, payday loans have become the symbol of ultimate financial distress. The payday loan industry suffers from a poor reputation rivaled only by the tobacco industry. Lately, I've done a fair amount of research on the economics behind short-term cash advances. In the course of that research, I've come across some information and resources you should know if you are considering a payday loan. So in this article we will discuss the cost of payday loans, state regulation of the industry, and some general guidelines on how to evaluate lenders.
Let's begin with some information that may surprise you. Who is the "typical" payday loan borrower? Here are the stats:
- More than 60% of payday loan borrowers are women
- The average age of a borrower is 25 to 54
- The average annual income is $25,000 to $75,000
- Borrowers have checking accounts (typically a requirement for a loan)
- Borrowers are employed (also a requirement for a loan)
What payday loans cost
Are payday loans expensive? That seems like a silly question, but believe it or not, the answer is hotly debated among professors, advocacy groups, state legislators, and of course the cash advance industry. Here's what all the fuss is about.
A typical $100 loan held for 7 days will cost $15. It's important to understand that the actual cost will vary from lender to lender and from state to state. So, is $15 expensive? Advocacy groups say yes, and use the annual percentage rate (APR) of the loan to support their views. A $15 fee on a 7-day $100 loan results in an APR of more than 700%.
Payday loan industry groups counter that using an APR to evaluate a short-term loan is misleading. They also argue that it is expensive to process short-term loans, particularly once you factor in defaults. In the final analysis, we can all probably agree that we'd rather keep the $15 for ourselves, but spending it once on a loan would not break the bank, either. And this brings us to a critical aspect of payday loans.
State regulation of the payday loan industry
States regulate the payday loan industry in a variety of ways. In addition to disclosure requirements, many states cap the interest rate or fees lenders may charge, limit the number of loans a borrower can obtain each year, or both. Ohio, for example, recently capped payday loan fees at 28% APR. The advocacy groups cheered the legislation while cash advance stores left the state. Some applaud this move, others wonder where borrowers will go to get short term loans now.
I generally take the view that the government should not decide what is best for you and me. Of course, the government does that all the time. Regardless, it's important to know that in some states, payday loans are effectively outlawed.
Chronic payday loan borrowing
The real cost and risk of payday loans comes in the form of chronic borrowing. Study after study shows that the occasional use of short term loans to address a financial emergency can actually minimize financial loss to the borrower (by avoiding more expensive options such as late fees and bounced checks). The problem arises when borrowers repeatedly tap payday loans to finance a lifestyle they can't afford.
In fact, many borrowers rollover payday loans, incurring additional fees that amount to more than the actual amount borrowed. And there are some in the industry that encourage this practice by only requiring the borrower to pay back the fee at the end of the loan. The result is another payday loan to cover the principal amount with a second fee tacked on to the total balance.
The lesson here is do everything possible to avoid rolling over a cash advance.
How to find the "best" payday loan lenders
If you have decided to get a payday loan, there is one resource you should look to before you do--Community Financial Services Association (CFSA). The CFSA is an association representing the payday loan industry. That is important to understand; the CFSA does not represent consumers. However, it has established industry best practices that its members must comply with. CFSA also maintains a list of payday loan and cash advance companies that adhere to its best practices. For example, FastWire Cash is a payday lender that is a member of the CFSA that represents that it adheres to CFSA's best practices.
Please don't consider this an endorsement of the CFSA or any of its members. But if I were ever in a position to obtain a payday loan, this is where I would start.
Alternatives to payday loans
No article on payday loans would be complete without a list of alternatives. So if you are in a difficult financial spot and considering a payday loan, check out these other resources.
Dave Ramsey has helped many people climb out of financial turmoil and offers some really sound money management strategies. The M-Network recently published a series on his program, and here are the links:
- Dave Ramsey’s Baby Steps Overview - Cash Money Life
- Step 0: No More Debt! No More Debt - Debt-Free Revolution, No More Debt - Single Guy Money.
- Step 1: $1,000 to start an Emergency Fund - Gather Little by Little.
- Step 2: Pay off all debt using the Debt Snowball - I’ve Paid For This Twice Already.
- Step 3: 3 to 6 months of expenses in savings - Being Frugal.
- Step 4: Invest 15% of household income into Roth IRAs and pre-tax retirement - The Dough Roller.
- Step 5: College funding for children - My Two Dollars.
- Step 6: Pay off home early - Moolanomy.
- Step 7: Build wealth and give! - Plonkee Money.
- Wrap-Up: Dave Ramsey’s Baby Steps - Being Frugal, Dave Ramsey’s Baby Steps - I’ve Paid For This Twice Already.
If you are looking for borrowing alternatives, you can consider Prosper, a peer-to-peer lending site, or credit cards. Credit cards should not be viewed as a long term solution, but if managed well, can be an inexpensive source of short-term cash.
{ 2 comments… read them below or add one }
I think this is a good assessment. Payday loans, credit cards, or other loans should never be a long term solution, but can be effective when used as they are intended – as a short term means to get by.
The most important thing is to change your money habits. As you mentioned, I think Dave Ramsey is a good place to start.
What ever happened to the original poor man’s lender – the pawn shop? Here you have a secured loan. If the item is never redeemed, the person’s creditworthiness is not affected. I used to work in a pawn shop. The typical customer was a regular, usually doing some kind of transaction that would net some money, but needed a stake that he didn’t have.
Payday lenders are a different breed, as they use debt collection techniques to harangue their borrowers.
Regardless of how people borrow, the root cause of this mess is relaxed borrowing criteria and people’s wants. I don’t understand how people can afford to pay for their cable/satellite TV costs, and their cellphone costs. The cost for texting is ridiculous, yet somehow parents are springing for it. Of course, I don’t have a teenager anymore.