Payday loans could spur costly debt cycle

Source: MARKETWATCH

By Jennifer Waters, MarketWatch

Last Update: 12:01 AM ET Jul 30, 2012

CHICAGO (MarketWatch)Payday loans are meant as a stopgap for the fiscally pinched. But in many cases, these short-term loans, mired in hefty interest costs, perpetuate a costly cycle of escalating debt.

A payday loan is like a cash advance on your paycheck. Marketed as a temporary solution to a short-term setback such as car repair or emergency medical issues, these loans are typically expected to be paid back in two weeksthe usual pay cycle.

But what happens, a recent study by the Pew Charitable Trusts found, is that most borrowerssome 69% of first-time borrowersneed the money not for a crisis but for everyday necessities. That leads to repeat loans.

Payday loans are legalized loan sharking designed to get people into debt, says Kathleen Day, a spokeswoman for the Washington, D.C.-based Center for Responsible Lending. Why would lending to someone in financial straits at outrageous interest rates be considered a good thing?

Amy Cantu, a spokeswoman for the Community Financial Services Association of America, the industrys Alexandria, Va.-based trade group, responds that consumers need a variety of credit options. Of the payday loan, she says: We never said it was the right option for every consumer in every situation, but it definitely has a place.

Typically, a payday lenderusually a check-cashing or finance companygives the borrower the amount needed and levies a fee. The borrower, who must have a checking or debit account, either writes a personal postdated check or authorizes the lender to withdraw the amount from the account.

The fees are generally based on a percentage of the loan or on the increments of money borrowed. Payday loans are treated like other types of credit by the Federal Trade Commission and lenders must disclose the finance charges and the annual percentage rates, which may vary from state to state.

In Illinois, the in-store payday-loan fee is $15.50 on a $100 loan, which equates to an annual percentage rate of 404%, according to the industrys largest nonbank lender, Advance America, based in Spartanburg, S.C. That assumes the loan is rolled over every two weeks for a year, something most states wont allow.

But if the loan is rolled over only three times, for example, the finance charge climbs to $62 for that $100. Those charges fuel the nearly $7.4 billion that some 12 million Americans spend on payday loans each year, according to the Pew study. At Advance America, the average loan amount is $375, which carries an average fee of $55.

When payday arrives, there is no extra money to pay back the loan and the cycle begins, according to Pew. If a consumer takes out an average of $375 a transaction and does that eight times a year, the average $55 per-transaction fees will total $440. Thats assuming the loan is paid off in two weeks. If two of those transactions are rolled over three times each, the fee reaches $534.

People are paying a lot more in payday loan costs and fees than they anticipate going in, says Nick Bourke, a project director with Pew. Thats true despite the lenders disclosures upfront, because people dont always understand what theyre getting themselves into.

CFSAA, the industry trade group, however, claims that the fees on bounced checks or missed payments could be substantially higher.

It takes the average borrower 18 days to pay each loan off, according to the Pew study and Advance America. This can lead to a spiral of debt if the loan is continually renewed rather than repaid when its due, says Greg McBride, a senior analyst at Bankrate.com.

Here are five things to consider before you turn to payday loans:

Do you really need it? More than 80% of borrowers told Pew researchers that if payday loans werent available they would trim expenses. Many also would delay paying some bills, rely on friends and family, or sell personal possessions, according to the report.

It will take you longer to pay it off than you think. The Pew study found and Advance Americas statistics confirm that borrowers take out an average of eight loans a year. That means youll be wading in five months of pricey debt.

There are other options. Choices include banks and credit unions. It could be cheaper to get a cash advance on your credit card at a 29.99% annualized interest charge.

It could ruin your credit score. Though payday lenders dont report what you borrow to credit agencies, they do report what you dont pay back in full. It is accounted as an uncollected debt.

Payday lenders rely on your bad financial habits. The profitability of payday lenders depends on repeat borrowing, according to a report by the Federal Reserve Bank of Kansas City.

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