Payday loans: a financial trap for cash-strapped borrowers

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2010 has been a topsy-turvy year for the American consumer.  The economic recovery is continuing at a morbid pace, and the job market remains bleak.

The recession has left many American consumers short on cash, while monthly bills and short-term debts still weigh heavily on households across the country.

In the year-end 2009 Financial Capability Study, the U.S. Treasury Department and the Financial Industry Regulatory Authority reported that nearly half of those surveyed said they had difficulties covering monthly expenses and paying bills.

Furthermore, more than one in five Americans said they’ve engaged in non-bank, alternative borrowing methods—including risky short-term borrowing known as payday lending, according to the report.

For those in desperate need of cash, payday lending is easy—lenders can be found almost anywhere (check cashiers, finance and other companies), and cash is given to you on the spot.

But for individuals searching for short-term cash to pursue long-term financial freedom, payday lending is a terrible idea.

How it works:

Let’s say you need $300 to pay a monthly utility bill, and you need to borrow money now to pay it.  Once you find a lender—often at a storefront location—you write them a $330 personal check, with an added fee, to borrow the amount for up to 14 days—the amount of time you have to repay the loan.

On the day you write the check, the payday lender agrees to hold it until your next pay day.  At that time (hopefully at or less than 14 days after you took the loan), the lender deposits the check and you redeem the check by paying the $330 in cash, or you roll over the check by paying a fee to extend the loan.

In this example, the Annual Percentage Rate, or APR, is 260.71 percent!  And if you get in the habit of extending the loan period, you could easily end up using a lot of the money you originally borrowed to pay off the stack of fees that have piled up.

“If somebody is going to use this system [more than one time] for..quick cash, they’ve got some other [financial] issues going on,” said Michael Eisenberg, a certified public accountant and a member of the American Institute of Certified Public Accountants.

Payday lending isn’t legal in all states, though 37 states—including Illinois—have regulated the practice. You don’t need a credit check to receive the loan and the fees tagged onto the loan can be huge.  Oftentimes, $15 to $50 is charged for every $90 borrowed, according to the Illinois Attorney General, Lisa Madigan.

“Many consumers who take out short-term loans are doing so as a last resort to pay their bills and provide for their families,” Illinois Governor Pat Quinn said in a June 24 statement after signing a law that put a cap on the interest rates payday lenders can charge.  Under the new law, the interest rates “will be capped at 99% for loans under $4,000 and 36% for loans greater than $4,000.”

“It is all too easy for lenders to take advantage of [borrowers] by raising interest rates and setting very short repayment periods, “Quinn said.

Payday loans work best for consumers who plan to use them on a one-time-only basis, although most debt-ridden consumers who use payday loans abuse this concept, stressed Barbara Stark, director of community development and education at American Debt Counseling Inc., a nonprofit debt counseling firm.

“What’s happening now is consumers that are in desperate debt continue to use payday loans and it becomes a trap.”

Both Stark and Eisenberg recommend that those having trouble managing their short-term debts seek the aid of a debt counseling service or a financial literacy website before resorting to payday loans.

“I would never recommend a payday loan for any situation,” Stark said.

Alternatives to payday lending:

  • Take out a small loan from a credit union.
  • Ask for advance pay from your employer.
  • A loan from family or friends.
  • A small loan from a community-based organization.
  • A cash advance on a credit card—though that could become costly as well, but not at the rate of a payday loan.

For more information on financial literacy, go to 360financialliteracy.org

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