Payday loans are small, short-term loans secured against the borrower’s next pay check.
For example, John and Jane Doe (our fictional couple who have no savings, no emergency fund and bills due) visit a payday loan company, flash John’s pay stub and walk out with $200 cash. John is expected to return to the office in two weeks — on his next payday — to pay back the $200 loan and the $30 fees (a typical amount).
For additional security, the lender required a post-dated check for $230. Assuming all goes well, John will pay back the loan on time. The crisis was averted, the bills got paid and John and Jane are out the $30 fee.
This being said, borrowing against a future paycheck could necessitate another loan, and might even kick off an ongoing cycle of payday loans.
But what if all does not go well? What if John and Jane aren’t able to make that $230 payment? What if their checking account does not have funds to cover that post-dated check? John and Jane would now owe additional fees to the lender plus a bounced check fee to the bank — charges which could easily add another $100 to the $230 already owed.
That $200 loan, in two weeks, has ballooned to $330, which they don’t have. Those fees, of course, will continue to build as long as the debt isn’t paid.
You get the idea. Payday loans, at best, are extremely high-interest (390% APR in my example) short-term loans. At worst, they can entrap a family into an escalating debt that could lead to repossessions, foreclosure and bankruptcy.
Maybe this is why payday loans are regulated in 37 states and illegal in the other 13. Perhaps this is why federal law, in 2007, capped the interest rates at 36% APR for payday loans to military personnel. These loans have been tabbed “predatory” with good cause.
My advice? Don’t play with snakes and you won’t get bitten.
JOE PLEMON is a certified financial counselor. Email your questions on personal finance to Joe at email@example.com.