Every year 12 million U.S. consumers take out a short-term payday loan. Most are faced with a financial emergency and plan to repay the money quickly. Most, however, quickly discover they can't.
"I fell on hard times and decided to take out a small payday loan," Tareeka, of Jackson, Miss., wrote in a ConsumerAffairs post. "The company loaned me $600.00. I already made a payment of $486.00 so far and still owe $812 and only borrowed $600. This is paying more then double back."
Tareeka's story is far from unusual. A new report from The Pew Charitable Trusts found the average payday loan requires a repayment of more than $400 two weeks later. The average borrower, the report says, can only afford to pay $50.
The question never asked
If borrowers stopped to think, they might see the trap. If they are short of money now -- requiring them to borrow -- how are they going to be able to pay the money back, plus fees, in just two weeks?
But when people are in desperate straits, they often don't think ahead. When two weeks go by and they are unable to repay the loan, they have no choice but to borrow more money, starting the cycle all over again.
"Payday loans are marketed as an appealing short-term option, but that does not reflect reality," said Nick Bourke, Pew's expert on small-dollar loans. "Paying them off in just two weeks is unaffordable for most borrowers, who become indebted long-term. The loans initially provide relief, but they become a hardship.
Few can pay on time
Pew researchers conducted a nationwide telephone survey of payday loan borrowers to compile their findings. They learned that only 14 percent of borrowers say they can afford to repay an average payday loan out of their monthly budgets. That means 86 percent have to take out a new loan two weeks later, paying an additional fee. The fee itself might not sound like much, but repeated over and over every two weeks, it can add up to a lot. Viewed as an annual percentage rate (APR), it's typically around 400% APR.
Many people who take out payday loans do so to avoid asking family and friends, or using other resources, to meet their emergency expense. The report found that ultimately they have to turn to these very same options to pay off the loans.
Forty-one percent need an outside cash infusion to eliminate payday loan debt– including getting help from friends or family, selling or pawning personal possessions, taking out another type of loan, or using a tax refund.
Since its inception in the 1990s, the payday lending industry has established over 22,000 locations which originate an estimated $27 billion in annual loan volume, according to the Center for Responsible Lending (CLR), a consumer group that monitors U.S. lending practices. It maintains that repeated payday loans result in $3.5 billion in fees each year.
In recent years CLR has called attention to the fact that a few major banks have begun making payday loans. These banks, the group says, are making short-term loans with triple-digit interest rates, essentially duplicating the storefront payday businesses that routinely trap lower-income borrowers in long-term harmful debt.
A recent survey by the Federal Deposit Insurance Corporation (FDIC) shows that most banks offering small loans tend to give borrowers 90 days or more to repay, with an annualized interest rate of 36% or less.
Banks get into the act
By contrast, banks pushing payday loans charge annual interest rates in the triple digits. For a typical 10-day loan costing $10 for each $100 borrowed, the effective APR is 365%.
This type of lending by non-depository payday lenders -- meaning businesses that aren't banks -- is prohibited or significantly restricted in 19 states. In some cases, CRL says these big banks are undermining state laws by making payday loans even where they have been banned.
Payday loans remain a problem for low-income consumers, perhaps because there are almost no other credit options for payday loan customers. They often turn to payday loans because they can't get a credit card or bank loan.
Don't be unbanked
What's the solution? Rather than imagining that government will ride to the rescue and crack down on payday lenders, low-income consumers need to explore their options ahead of time. Or, the borrow a slogan from the Boy Scouts, they need to be prepared.
Many low-income consumers don't have bank accounts. They may be paid in cash or they may simply take their paycheck to a local retailer to cash it. This is what is called being "unbanked" and the problem with it is that the consumer does not build a relationship with a financial organization that can provide credit on reasonable terms.
One reason for this is that commercial banks typically shun the working poor. A ConsumerAffairs reporter recently witnessed a telling incident at a Bank of America branch in Northern Virginia. A man dressed like a restaurant kitchen worker approached a teller and asked to cash his paycheck.
"Sir, you come in every week and cash your paycheck," the teller snapped as a manager sauntered over. The consumer protested that he had a checking account at the bank.
"Yes, but you're not using it as a checking account. You just come in here and cash your paycheck each week," the manager interjected.
Words were exchanged and the affair ended with the bank closing the man's account and sending him back into the street with his uncashed paycheck.
Perhaps the best solution open to the kitchen worker and others like him is to find a local credit union -- a non-profit organization that offers checking, savings and loan services, often on better terms than banks.
At a credit union, just like a bank, the kitchen worker could arrange for direct deposit of his check and get a checking account and debit card that he could use for his regular expenses.
Even though he might have to pay a few dollars a month, he would be building a relationship with the credit union that would at least give him a chance of getting a loan on reasonable terms when he needed one.
The Credit Union Lookup site will help you find credit unions in your area. Some credit unions are tightly restricted to certain groups -- such as employees of the local school district. But many others are more liberal in their membership requirements. As always, it pays to shop around.