Pitfalls of Payday Loans

Payday loans are rarely a good idea. Here's a list of the risks and dangers of payday loans.

If you are considering a payday loan, you should be aware of the pitfalls of this type of loan when compared to more traditional loans. The dangers of payday loans include:

  • extraordinarily high interest rates
  • high fees
  • automatic payment requirements
  • repeat borrowing to pay prior loans
  • unscrupulous lenders
  • unscrupulous debt collection practices, and
  • damage to your credit rating.

You should only consider a payday loan if you cannot get a loan from a traditional bank or cannot get money any other way. It should be a last resort.

What Is a Payday Loan?

A payday loan is a short term loan offered at a very high rate of interest. A typical payday loan is due in full on the date the borrower receives his or her next paycheck or benefit payment. These loans may have interest rates of 375% or higher. The term payday loan is also used to describe a loan with a slightly longer repayment period (up to six months) where payment is due on the date the borrower gets paid. These loans are referred to as installment loans and often have origination fees and high interest rates.

People can often get a payday loan online or at storefronts operated by payday lenders.

Risks and Downsides to Payday Loans

Payday loans carry significant risks to the borrower.

High Interest Rates

A typical payday loan has an interest rate in excess of 375%. Some rates have been reported as high as 591%. Compare this to credit card interest rates, which average around 13% to 15%.

Some states’ laws limit the interest rate that payday loan lenders may charge. You can consult with your state’s consumer protection agency to find out whether limits apply in your state.

High Fees

Payday loans often have high fees that are separate from the interest rate. For example, the lender may charge an “origination fee” or a “processing fee”. In some cases, these fees are a way for the payday lender to get around interest rate caps imposed by state law.

The lender is supposed to disclose these fees in the paperwork you receive with the loan, and you must pay them even if you pay the loan off early. Read your loan paperwork carefully before you agree to the loan so that you know what fees, if any, will be charged.

Automatic Payments

Payday lenders typically require some form of automatic payment, such as a post-dated check or automatic withdrawal from your bank account. If the money is not in your bank on the day the payment is posted, you will incur overdraft fees.

If your bank does not honor the check or automatic debit, you may end up owing the payday lender additional interest and possibly collection fees. (If you have a payday loan and no longer want automatic deductions from your bank, review Nolo’s article How to Stop Automatic Payments on a Payday Loan.)

Repeat Borrowing to Pay Prior Loans

If you are unable to repay your loan when it is due, you may be tempted to take another loan to pay off the first. This leads to a cycle of debt, one that you may eventually be unable to end. Borrowers often find themselves making interest only payments on the due date, without ever lowering the actual amount due.

Unscrupulous Lenders

Many states have laws that require payday lenders to be licensed in order to offer loans. However, many unscrupulous lenders evade this requirement. These lenders operate exclusively online and are usually located overseas, although that may not be apparent from their websites. Some may even have an address that appears to be a U.S. address, but is actually a mail drop at a retail store that rents mail boxes.

You must provide sensitive financial information, such as bank account numbers, in order to obtain a loan. If you select an unscrupulous lender, your information may be misused. In addition, if your lender operates outside of the United States, you may not receive the benefit of your state’s consumer protection and lending laws. These laws may also not apply to lenders owned by Native American tribes. In general, Indian tribes are not subject to state consumer protection or lending laws.

Here are a few ways to avoid ending up with a dishonest lender.

  • Research the lender before you commit to the loan.
  • Check for the lender’s address. It should be displayed on its website and in the loan papers. If you cannot find an address, do not take the loan.
  • If your state requires the lender to have a license, verify that the lender is in fact licensed. Do not deal with an unlicensed lender.

Unscrupulous Debt Collection Practices

Many people report that debt collectors have contacted them a year or more after they repaid the payday loan. Often, unscrupulous lenders provide these debt collectors with your confidential financial information.

The debt collector will state that you never paid the loan, and attempt to intimidate you into making additional payments. It may contact your neighbors or employer, or falsely claim that a lawsuit has been filed against you or that you will be arrested if you do not send immediate payment.

While these tactics are illegal, many of these phony debt collectors are located overseas and can operate outside the law. (Learn more about laws that prohibit what debt collectors can do.)

If you do take out a payday loan, keep all paperwork related to the loan, including evidence that you repaid it. If you suspect your financial information is being misused, contact your local law enforcement agency.

Damage to Your Credit Rating

If you don’t repay the loan as agreed, the payday lender may report your nonpayment to a credit reporting agency. This information will remain on your credit report for as long as seven years. Negative information on your credit report can cause you to pay higher interest rates or be turned down for credit.

What to Do If You Have a Problem With a Payday Lender

If you have a problem with a payday lender, you should file a complaint with the Consumer Financial Protection Bureau (CFPB). The CFPB is a federal agency that enforces regulations applicable to payday lenders, banks, and other financial institutions. The CFPB will work with your lender or bank to resolve your complaint. Submit a complaint at http://www.consumerfinance.gov/complaint/.

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