We take an in-depth look at the Payday Loans industry
Are you short on cash this month? Are you considering applying for a payday loan?
Before you commit yourself to a binding legal agreement to pay a creditor, you should think about the deal. Payday loans serve their place in the world of financial instruments. However, they come with a set of terms and conditions that are not favorable to the consumer.
A payday loan has its pros and cons like any other debt. It could help you out of a tight financial spot, or it could cost you more than you expect.
Let’s unpack payday loans to decide if they are ever a good idea when it comes to loaning money.
Online Payday Loans
We have covered a number of companies which offer payday loans online, these companies will provide short-term installment loans if you need one in a hurry. Read through our reviews to see if one is suitable for you.
Our pick is OppLoans, these offer a lower rate of interest than other similar providers.
What is a Payday Loan?
A payday loan is a financial instrument offered by micro-lenders. Banks don’t get involved in the payday loan market, they feel it’s too risky, and the chances of default are high.
Payday lenders have insurance coverage to mitigate the risk of lending to unqualified borrowers. In the case of a default, a policy with a company like AIG, one of the biggest insurance underwriters in the world, covers the lender’s asset.
A payday loan is a short-term loan that you pay back to the lender with your next paycheck.
Payday loans are incredibly popular in the United States, and every state has multiple payday lenders available.
Around 12-million Americans apply for a payday loan each year. The payday loan market has a value of nearly $10-million, and more than 11-percent of the population say they used a payday loan at some point in the last 2-years.
Lenders issue payday loans for small amounts, with the average loan size being between $500 to $1,000. The average age group for using payday loans is between 25 to 49-years old, with African-Americans being twice as likely to take out a payday loan compared to other race groups. Typically, people who take payday loans earn between $15,000 to $25,000 per year, and they have no college education.
Statistics show that renters are twice as likely to use payday loans. Divorcees are more likely to use the facility than married couples as well. People who utilize payday loans cite financial hardship and unforeseen expenses as their reason for needing money quickly.
More than 69-percent of all borrower’s state that they use the money to pay for cash shortfalls in their monthly budget. The borrowers spend the funds on their credit card bills, or to cover utilities, food, and rent.
Most payday lenders advertise the service as money to cover emergency expenses. However, the research shows that only 16-percent of all borrowers use the money for this reason. Most borrowers visit a store-front location to apply for their loan, with the highest demographic for loans being the Southern States.
Read: OppLoans Review: Installment Loans for Borrowers with Bad Credit
Why Don’t Banks Offer Payday Loans?
When a bank loans you money, it needs to follow the procedure. The loan manager will review your credit report to look at your FICO score. Your credit report is an assessment of your financial responsibility to lenders. If you have outstanding collection notices and a weak FICO score, then the chances of the manager approving your loan facility are non-existent.
Banks also don’t like to loan small amounts to customers. They prefer that clients use a facilitated instrument, such as a credit card, to bridge their cash position during the month. In the past, banks and private lenders would flood the market advertising credit cards to anyone. However, today, you need good credit, proof of income, and a good credit score to qualify for a credit card.
In the wake of the 2008 Great Financial Crisis, banks are more stringent with lending to consumers. However, consumer debt is well over $14-trillion as of Q4 2019. Since the average American has a FICO score of 695, banks aren’t interested in taking on the riskier subprime market. Instead, they leave it to the micro-lenders. If you have a low credit score, and you need money, a payday loan might be your only option.
What do You Need to Qualify for a Payday Loan?
Most payday lenders only require your social security number to qualify for a loan. In some cases, the lender may ask for proof of income, and you may have to provide them with a copy of your payslip.
Payday lenders don’t loan substantial amounts to consumers, and they help them mitigate risk in the deal. The business model works on the idea that consumers will pay off the debt before other creditors at the end of the month, due to the high-interest rates involved with taking the facility.
Do You Need a Good Credit Score for a Payday Loan?
As mentioned, banks check your credit score when applying for a credit card facility or a personal loan. Your credit score consists of five weighted factors that show your level of responsibility in handling credit.
- Payment history – Do you pay your creditors on time? Late payments affect your credit score.
- Age of credit – How old are your credit accounts? Banks like to loan money to people that have a history of successfully paying their creditors.
- Credit mix – Banks prefer if you have numerous forms of credit, such as a mortgage, student loans, and auto loans. The lender views this behavior as showing you know how to manage your debts.
- New credit applications – The banks ‘don’t like it if you have too many hard inquiries into your credit report. This behavior shows that you are desperate for a loan or credit facility.
- Credit utilization ratio – This factor shows how much of your credit facility is currently in use. Banks want to see you use less than 30-percent of your available credit. Therefore, if you have a credit card with a $3,000 limit, it’s best if you ‘don’t have more than $1,000 charged to the card.
The combination of these factors creates your FICO credit score. Banks rely heavily on your credit score when assessing you for a new loan facility. If your score is 800+, then you can expect to get the best terms from the bank for your loan. If your score is between 680 and 750, you have average credit and may receive a loan at a higher APR than those with excellent credit scores. However, if you have a subprime credit score below 670, lenders may refuse you a credit facility, or offer you very high APR.
So, where does that leave people with average or subprime credit scores that are looking for a loan? These individuals have to go into the private lending market to source the funds they need. Private micro-lenders ‘don’t have to follow the same procedures as big banks when qualifying a customer for a loan.
As a result of the relaxed criteria, ‘it’s possible to get a payday loan without good credit. In most cases, the only qualifying criteria are that the borrower has a job. All it takes is a payslip for proof of income, and the customer gets the money they need.
Read: How to Repair a Bad Credit Score: Complete Guide
What APR Does a Payday Lender Charge?
Payday loans sound like a great idea so far. Lenders don’t check your credit score, and you get cash deposited directly into your bank account within 24-hours.
The problem with payday lenders is the APR they charge on loans. APR stands for annual percentage rate, and it’s how payday lenders make their money. In most cases, an unsecured credit card facility can have an interest rate that’s as high as 24-percent.
This APR of 24-percent means that you’re paying back $24 in interest fees for every $100 you borrow. Some cards have introductory periods where you don’t pay any APR and then switch to a higher rate after the initial period expires.
Most secured credit facilities will charge between 15 to 16-percent interest per annum. This amount doesn’t include account fees, card fees, and any other costs involved with the management of the facility by the lender.
What is a Predatory Lender?
Here’s the shocker. Studies by the Consumer Finance Protection Bureau (CFPB) show that the average APR on a payday loan is around 400-percent. That figure is nearly 17-times what you would pay for the most expensive credit facility at a bank. In some southern states, such as Texas, Ohio, and Utah have APR costs approaching 700-percent.
Payday lenders charge such high-interest rates for a reason. These micro-lenders are participating in a high-risk market that has a high delinquency rate. The subprime lending market almost ruined the economy in 2008, and that’s one of the reasons why banks don’t take a risk in this market anymore.
In return for taking the risk of loaning you money, payday lenders believe they have the right to charge these high APRs. Question a payday lender about ethics, and they will tell you they clearly state all of the terms and conditions, along with APR on the loan agreements.
This statement is accurate, and the financial services board requires all lenders to make the consumer fully aware of their rights, as well as the terms and conditions of the contract. However, the issue is that consumers often don’t bother to read the terms and conditions of the loan before signing the agreement.
Consumers care about getting the money as soon as possible to cover their cash shortfalls, and they’ll worry about the costs of the loan later. Unfortunately, borrowers don’t have an understanding of how this interest rate adds up to a monstrous debt in a short period.
As an example, if we take a payday loan for $500 at an APR of 391-percent, you’ll owe the lender $575 two weeks later. Many consumers find that they don’t have the money to pay the loan and choose a rollover. Often, they don’t realize that a rollover cost is going to leave them owing over $1,000 in less than 3-months.
Rollovers Are a Regular Occurrence
Despite the high costs involved with loaning money from payday lenders, many people decide to roll over their loans. Studies by the CFPB show that more than 80-percent of all payday loans are in a rollover. Further research also indicates that the average payday loan user takes around 10-loans per year, and spends nearly 200-days of the year in debt.
The cost of the loan takes it longer to recover their budget, forcing them to take on more loans. As a result, the borrower finds themselves in a vicious debt-cycle that’s challenging to escape. Some studies show that the interest on payday loans can account for as much as 36-percent of a borrower’s annual salary.
Payday lenders don’t advertise the high APR, and they also don’t tell you about rollovers. They leave it to your best judgment that you know how to handle your affairs. Unfortunately, many Americans are irresponsible lenders, and they end up defaulting on the loans. Delinquency rates for payday loans continue to rise, with more than 20–percent of loans in delinquency status in 2019.
When Is It a Good Idea to Use a Payday Loan?
After reading the facts on the APR charged by lenders on payday loans, it’s easy to write them off as a financial instrument. However, there are occasions where payday loans have a place in your finances. If you experience a medical or financial emergency where you need cash in 24-hours, then a payday loan is an excellent option.
However, you need to use the instrument as directed and pay back the lender at the due date. Failing to do so will end up costing you on interest payments. Leaving the debt to snowball is a bad idea, and avoid rollovers wherever possible.
Wrapping Up – Weigh Your Options Before You Sign
Before you accept the loan agreements, take the time to reads the terms and conditions. Your lender will have to provide you with a copy by law. Pay attention to the sections about APR, and the rollover periods.
If you do decide to go with a payday loan, make sure you can pay it back. Never take on debt you can’t afford, especially in an emergency.
