Why payday loans are a bad idea

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You're in need of money and you’ve considered several alternatives such as borrowing from a relative, a friend or even from the bank. Still can't find a solution? Have you thought about applying for a payday loan? The question is, what is a payday loan?

Are you considering a payday loan? Make sure you inform yourself!

Payday loans: What are they?

A payday loan allows you to borrow money based on a commitment to pay it back when you get your next paycheque or regular income.

Most lenders don't perform a credit check before granting a payday loan. Typically, they ask the person:

  • to prove they've had a job for the last three months;
  • to provide proof of their address, such as a utility bill;
  • provide them with their chequing account information.

The payday loan repayment period is short and depends on your personal situation: it typically ranges from 14 to 28 days. The longest period you can expect is 62 days, or about two months. Until your payday loan is paid off, you can't get another one.

When a payday lender agrees to lend you money, you must sign a loan agreement. By signing a loan agreement, you agree to pay back the loan, along with any interest and fees charged by the lender. It is essential to know that payday lenders charge a much higher interest rate and fees than banks, credit unions or credit card companies. If you need money for a short period, keep in mind that it would cost less to use your credit card.

Usually, payday loans must be repaid in one lump sum at the end of the term. But if the loan you are applying for is your third or more in 63 days, the lender should offer you an extended payment plan.

Before you sign a loan agreement, make sure you’re well informed on how exactly your loan will work. For example, you need to be clear about how much you are borrowing, how much you must pay back, how many days you have to pay it back,

how to repay the amount and whether you can cancel your loan agreement.

It's generally recommended that you think about alternatives before applying for a payday loan. For example, you may want to consult a credit counselor at a non-profit agency. A credit counselor can help you develop a plan to pay off your debts.

The Risks of Payday Loans

As a rule of thumb, a payday lender charges much higher interest rates and fees than traditional banking institutions, credit unions or credit card companies. In other words, this explains why payday loans are risky - they can actually make your money problems worse. In fact, that's a reality for many individuals who choose this option.

If you don't pay off your payday loan by the agreed-upon date, here's what the lender can do:

1. Add late fees and interest, which will make your loan even harder to pay back. Certain lenders can even charge as much as 60% interest if you don't pay your loan back on time. Always make sure to read your agreement's terms and conditions to find out what interest rate applies.

2. Send your file to a debt collector, so that they can arrange for you to repay the loan. This will also hurt your credit, and you'll have trouble borrowing later on.

3. Go to Small Claims Court. If the lender wins, the court may allow the lender to claim an amount of your money or property portion. It could also allow the lender to take a part of your pay. This is called wage garnishment.

Furthermore, the lender cannot grant you another loan to pay off your payday loan.

How Much Will Your Loan Really Cost?

As of 2018, the cost of borrowing for a payday loan must not exceed $15 per $100 borrowed. This rule may lead users to believe that the interest rate on their loan is 15%, but this is not the case.

Normally, interest is calculated over a one-year period. Banks, credit unions and credit card companies usually charge an annual interest rate, regardless of the repayment period. On the other hand, payday loan repayment terms generally range from 14 to 28 days but can be as long as 62 days at the most. As a result, the cost of borrowing is equivalent to an annual interest rate much higher than 15%.

The following table demonstrates the annual interest rate for a $100 loan with a cost of borrowing of $15, based on the number of days you would have to repay the loan.

# Days to Repay LoanEquivalent Annual Interest Rate
14 days391%
28 days196%
62 days88%

For example, if you use your credit card to make a $400 purchase and the annual interest rate is 15%, then the interest will total about $5 per month or $60 per year. On the other hand, if you borrow the same amount from a payday lender that asks you to pay $60 every 14 days, your loan will cost you about $129 a month or $1,543 a year!

If, instead, you use your credit card to get a cash advance, the interest rate will probably be higher than the usual annual rate, but the final cost of borrowing will be lower than if you deal with a payday lender.

If you need money for a short time, think of using a credit card instead; it will cost much less than a payday loan. If you can't, keep in mind that there may be other solutions to your money problems. To get you started, you may want to talk to a credit counselor at a not-for-profit agency.