If you know a little about payday loans and other services provided by this type of alternative financial services firm, you probably understand why I wasn’t excited. A payday loan is a small short-term loan, often as short as two weeks – it’s designed to get you by until your next payday. Here’s how it might work:
I (the customer) would go into a payday lending business and write them a check. I would date the check with the date of my next payday (perhaps two weeks from now). If I wanted to borrow $300, they might tell me to write the check for $360. I leave my check with them and walk out with $300 cash. When the date on the check comes around, they send my check to the bank and get paid.
It’s easy. Or at least it seems easy. However there are (at least) two problems:
- I’ll be short on money next month, since $360 will be immediately spent. Therefore it’s very possible that I will be back to the payday lender for another loan (paying another fee). This cycle can repeat many times. Worse, the amount I’m borrowing each time might increase. Even if I do succeed in reducing the amount I borrow each time, it may be months before I’m out of debt. Taking a payday loan is like digging a hole and jumping in — it can be hard to climb out.
- Cost. Paying $60 to borrow $300 might seem worth it at the time. Sixty dollars is 20% of $300. Twenty percent is not a great interest rate, but it’s not that bad, right? But wait — that was just a two-week loan. When I borrow money, the key factor is the Annual Percentage Rate of interest (APR). If it’s 20% for two weeks, then it is actually a 520% APR. That’s not an APR I will brag about to my friends, but it’s typical for payday loans — they usually range between 300-800% if calculated as an APR.
The moral of the story? Anything that sounds like “easy money” is probably not. If you find yourself pinched for cash, think twice before turning to a payday loan as the solution to your problem. It may be a short-term solution, but what will be the long-term consequences?
p.s. The Federal Reserve Bank of St. Louis has a good page on alternative financial services (including payday loans and other services) to help you evaluate pros and cons before you jump in.