How Payday Loans Work

One of the most notable characteristics that set payday loans apart from other kinds of loans is the fact that their terms are typically much shorter. Following the approval of the loan, the money is normally expected to be returned (together with any applicable costs) on the borrower’s subsequent payday. It’s possible that this span of time will be one week, two weeks, or even one whole month.

Payday loans, in contrast to traditional loans, do not need the borrower to provide any form of collateral in order to be approved for the loan. In most cases, credit reports and credit scores are not included in the process of obtaining a loan. The following are some of the standards that must be met, according to the Consumer Financial Protection Bureau, in order to be eligible for a payday loan:

• A current account held in a bank, credit union, or on a prepaid card is acceptable.
• Documentation attesting to the receipt of funds from a job or other source
• Valid ID
• Having reached the age of 18 or older.

According to comprehensive study conducted by the Pew Charitable Trusts, around 12 million people in the United States use payday loans on an annual basis. According to findings from earlier studies conducted by the St. Louis Fed, it appears that many people have a love-hate relationship with them.

Instantaneous Funds and Recurrent Borrowing

Payday loans are marketed as a way to receive “quick cash” in the event of an emergency or to satisfy needs that can only be met in the short term; yet, many people use them repeatedly to make up for problems with having insufficient funds.

In a recent essay published by the St. Louis Fed, Senior Economic Education Specialist Jeannette Bennett explained that those with low incomes and higher-than-average poverty rates are the most typical borrowers of payday loans. According to research conducted by Pew, three quarters of all payday loans are obtained by borrowers who have already obtained 11 or more loans in the previous 12 months.

According to Bennett, the fact that the loans are being used to pay for essential needs is one rationale for the repeated use of the loans. According to Pew, as many as 58 percent of borrowers contend with the inability to fulfil their fundamental monthly obligations; thus, in practise, payday loans are frequently utilised to cover essentials such as rent and electricity.

According to Pew, the typical loan requires a payment of $430 to be made on the borrower’s next payday. Since the majority of borrowers do not have the ability to pay this amount, they are forced to either re-borrow the money or renew the loan. Therefore, individuals require the loans yet are unable to pay for them. People who do this end up dragging themselves into a never-ending cycle of debt because each new loan results in additional costs, which can equal or even exceed the amount initially borrowed.

How to Figure Out the Fees and Interest on a Payday Loan

Payday loans may appear to be a simple and quick solution to a short-term problem, such as the need for immediate cash; nevertheless, the actual costs associated with these loans are significantly higher than those associated with regular loans. According to Bennett, the average interest rate on a typical payday loan is an eye-popping 391%. This is an extremely high rate. That’s assuming it’s paid after the first two weeks have passed.

To provide some context:

• According to Bankrate, the average interest rate charged by credit card companies as of the beginning of July 2019 was approximately 17.8%.
• As of the end of May 2019, personal loans at commercial banks had an interest rate of 10.63%, as indicated by the economic data provided by the Board of Governors of the Federal Reserve System.

Why do payday loans have such high interest rates? The system that is based on fees. When compared to other kinds of loans, the high lending fees that are associated with the short-term nature of these loans cause them to be more expensive. Bennett makes this point clear.

When determining the APR, or annual percentage rate, associated with a payday loan, the interest and fees associated with the amount borrowed are compared to what the total cost would be over the course of a year. Take into consideration the following illustration, which was taken from a St. Louis Fed economic education lecture titled “So How Much Are You Really Paying for That Loan?”.

An illustration of a payday loan

In order to assist in paying for an automobile repair, Cecelia applies for and receives a payday loan in the amount of $400 for a period of two weeks. A fee of $60 is assessed by the lending institution. What does the APR stand for?

• First, to get the total amount of costs, add up all of the fees and interest charges.

Total fees (given) = $60

• In the second step, divide the entire amount of fees by the amount that was financed (borrowed).

$60 / $400 = 0.15

• The third step is to multiply the result by 365, which is the number of days in a year.

0.15 x 365 = 54.75

• Step 4: Divide the answer by the number of days that represent the length of the loan.

54.75 / 14 days = 3.91

• The fifth step is to insert a % sign after moving the decimal point to the right by two places.

This loan has an annual percentage rate of 391%.

Payday Loan Regulations

It may appear that the disadvantages of using payday loans outweigh their benefits due to the fact that they have the ability to start a never-ending cycle of debt. Payday loans have the potential to appear to be a choice that is convenient for some customers. They provide quick cash with few requirements for documentation. People with poor credit scores and those who are unable to qualify for traditional loans may find that they are their only option for obtaining a loan from this company.

Each state has its own set of restrictions due to the fact that they are aware of the risk of financial obligation that is associated with payday loans. Depending on the state you’re in, the regulations can be somewhat varied from one another. The laws that govern repeat borrowing, waiting periods in between loans, and maximum loan amounts vary from state to state. These are just some of the specifics that make up these differences.

Payday lending is expressly prohibited under the laws of some states. There are already regulations in place in seventeen states and the District of Columbia that either outright prohibit the practise or set laws that have the same effect of driving lenders out of business. (As of the beginning of 2019, this was the case; state regulations are constantly being updated.) 1 Loans from payday lenders are permitted in the state of Missouri.

The Consumer Financial Protection Bureau, sometimes known as the CFPB, was established in 2011 as part of the federal regulating system in order to safeguard consumers. The Consumer Financial Protection Bureau (CFPB) investigates payday loan practises and maintains communication with customers in order to use this data in the formulation of new federal rules.

Conclusion

Do you despise them or love them? Bennett warns borrowers to proceed with caution while dealing with payday lenders, despite the fact that payday loans might be useful.

She said that “Borrowing is costly without the power of knowledge,” adding that “As with all types of credit, borrowers need to be aware of what they are getting into when they take out a payday loan and avoid taking on debt they cannot afford.”