Many websites display advertisements for convenient “payday” or “cash advance” loans. The principal behind these loans is to advance consumers anywhere from $200 – $1,000 to get through a rough financial patch until the next payday. While the allure of these loans appeals to many a consumer, there are some things to consider before signing up for that personal bailout plan.
- Interest rate
The interest rate on these loans is an astronomical 200 percent or more APR (annual percentage rate). With many of these companies, a consumer borrowing $200, end up paying back $225 or $250 several weeks later; all thanks to that annual percentage rate. It may not seem like a lot of money at the time, but the problem with these loans is that many consumers become chronically dependent on them. In fact, some people admit to taking out a new payday loan to pay off an existing payday loan, resulting $650 – $1,300 or more, in interest charges tossed away annually –based on a bi-weekly payment example.
($25 x 26 weeks = $650)
($50 x 26 weeks = $1,300)
- Debt trap
Therein lies the debt trap. With cash advance or payday loans, the consumer is taking a big risk with his personal finances. First, he is risking not having the money to pay back the loan on the due date for a variety of circumstances, resulting in ever climbing interest rates and late fees. He is also risking added costs of refinancing the loan over and over again, becoming more like a hamster in a revolving wheel than a consumer. All of his disposable income is now eaten up in these interest rates and fees.
- What happens to your credit?
Part of the appeal of cash advance or payday loans is the fact that they are granted without a credit check. The lender doesn’t pull a credit history to approve the loan, and the loan doesn’t get reported on a credit history when it’s paid back. The only benefit to the consumer is temporary cash, accompanied by a high interest rate. These loans do not help build or establish credit, and with such a high cost to maintain, don’t make much financial sense.
However, if the consumer defaults on the loan, his credit report reflects that. In fact, a cash advance loan default is the only resulting impact to consumer credit reports. The defaulted cash advance or payday loan is put into collection after 30 days of non-payment, and immediately appears on a credit report, dropping scores substantially. Collection activities and negative credit consequences of a payday loan default follow a consumer for up to seven years; all the while accruing despicable amounts of interest and late fees in the process.
- Other, better options
The best option for cash strapped consumers is to keep a credit card on hand with a minimum $1,000 limit. For credit challenged consumers, a secured credit card with a deposit –and subsequent credit limit of $1,000-offers flexible repayment terms and far lower interest rates. Both options report payments to credit bureaus, ultimately helping your score.
However, the best solution overall is to have at least $1,000 liquid, in an emergency fund set aside in cash, avoiding interest payments and debt traps altogether.