Taking out a payday loan can seem like an attractive option when you need some quick cash. However, the prospect of a handful of money without much hassle comes with significant risks to your finances and mental health. Learn why you should avoid taking out payday loans under any circumstances, no matter how pressing your financial needs.
Predatory Interest Rates
Convenience always comes at a higher price, and loans are no exception. Payday loan providers charge service fees ranging from $10 to $30 for every $100 you borrow. Even on the lower end ($15 fee per $100), the resulting APR comes to 400%. This rate is 10 times more than the average rate that high-interest credit cards charge.
The cost of borrowing money on these terms is unbearable for most people and results in a higher balance than the original payday loan.
When you take out a payday loan, the terms you sign include a stipulation stating your consent for the lender to collect payment directly from your bank account. If you don’t have the money in your account when the due date arrives, the bank will likely charge you overdraft fees, which are usually around $33 per transaction.
These fees increase your lending costs, making payday loans costlier than your initial agreement.
Potential Impact on Credit Score
Taking out a payday loan is a no-win situation for your credit score. Lenders usually hand out payday loans without checking your credit score, so timely payments won’t positively impact your credit.
If you don’t pay back the loan, the payday lender sends the debt to a collections agency. When this happens, the collections agency begins sending you payment requests and reporting your debt to credit reporting agencies.
As a result of your unpaid loan, you may have a lower credit score and damaged credit history. Any actions requiring a credit report, such as buying a house or applying for a job, can suffer from defaulting on a payday loan.
They Create a Cycle of Dependence
The purpose of a payday loan is to give the borrower the liquidity to survive financially until their next paycheck. With over 36% of U.S. private businesses paying their employees biweekly, a short-term loan seems to make sense for employees. However, the high-interest rates result in a cycle of financial dependence for borrowers.
What does the cycle of dependence look like?
The cycle of dependence often begins if the payday lender states they cannot renew your loan. Renewing the loan means instead of settling the loan upon maturity, the lender rolls it over into a new loan with interest.
One of the loopholes lenders use to circumvent this legal obstacle is to issue the borrower a new loan to pay for the original one, escaping the strict definition of loan renewal. This process increases the financial burden on the borrower. However, they may not realize how much they incur in additional fees.
Many borrowers take out a payday loan to cover emergency expenses. When they don’t have the funds to cover their day-to-day expenses in addition to the loan payment, they opt to rollover their loan. If this happens continuously, the fees can grow to match the loan principal. If you can’t come up with the funds to cover the initial loan, paying back twice the amount on a fixed income is stressful.
Contact the Consumer Financial Protection Bureau if you’re a victim of predatory lending practices from a payday loan provider. This government agency monitors banks and lenders to ensure they abide by the laws governing financial institutions.
They Create Unhealthy Personal Finance Habits
One of the basic principles of building wealth for your retirement is saving money and investing it to earn interest. Healthy financial practices include minimizing your expenses and avoiding costly debt.
Alternatively, seeking to make ends meet in the short term with payday loans derails your long-term goals and reinforces unhealthy habits that can leave you in dire financial straits.
Your initial payday loan might help you in an emergency, but it may evolve to include paying the electricity bill, groceries, or gas regularly. The more you rely on expensive payday loans to cover everyday expenses, the less likely you will develop healthy savings practices.
People who depend on constant lending to make ends meet can sabotage their retirement funds and put themselves in a precarious financial position that impacts all aspects of their life.
There are No Safeguards
Taking out a business, home, consumer, or student loan comes with safeguards that protect the borrower and the lender. Banks and credit unions check your credit score, credit history, existing debt, and current income to ensure you can repay the loan. For borrowers, the limitations of this process prevent you from overextending yourself financially.
There are More Affordable Alternatives
Taking out an expensive loan that might fix things in the short term can cause financial harm in the long term.
The key to avoiding rash decisions is to mentally remove yourself from the situation. Panicking about the money you owe can cause you to overlook solutions that are viable and accessible as long as you put in the effort to pursue them. Once you start thinking about your problem without emotion, you are likely to discover better alternatives.
Communicating with your creditors can give you a way out of your financial problem. If you can convince creditors that you intend to make good on your obligation as soon as possible, they may be willing to offer a deadline extension or a payment plan.
A personal loan from a family member or friend can provide you with the needed funds in the short term. Relatives and friends are unlikely to charge interest and agree to a tolerant repayment plan.
If you’re juggling multiple financial obligations with varying interest rates and deadlines, consolidate your debt by speaking with your bank or credit union. A cash advance from a credit card could offer a more sustainable option than a payday loan.
Choose the Best Option
Making informed financial choices comes from learning how to manage your income and pay back debts on time. Credit counseling provides helpful knowledge on budgeting, saving, and avoiding bad credit.
Learn more about how loans can affect your credit score from Finance is us. Apply these best practices to keep you out of financial trouble while saving for the future.
Disclaimer: All content on this site is information of a general nature and does not address the circumstances of any particular entity or individual, nor is the information a substitute for professional financial advice and services.