Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Payday Loan

What it is:

A payday loan is an advance on one’s paycheck. Independent lenders and some large banks offer the service.

How it works (Example):

John Doe’s checking account has $12 in it but he has to pay the guy who fixed his refrigerator. The repairman doesn’t take credit cards. John needs to pay the $500 invoice in the next five days or the repairman will take him to small claims court. However, John doesn’t get paid for 10 more days and doesn’t have any money saved.

One option is a payday loan. Typically, he can just walk into a payday-advance store, prove he has a paycheck  coming, sign a loan agreement, and write a check for the amount of the advance plus a fee. So if John wants a $500 advance, he or she might write a check for, say, $575. The lender gives the John $500 immediately and holds John’s check until the agreed-upon date, which is usually the next payday.

Though the process is relatively simple, the associated fees often complicate the situation. Borrowers often roll the principal over into a new payday loan because when payday comes, they don't have the money to pay off the debt in full. Unlike credit cards or loans, payday loans can't really be paid off in installments, which is why so many borrowers end up rolling their debt over into a new loan with new fees. Thus, the average annual interest rate on a payday loan works out to about 400%, according to a study by the Center for Responsible Lending. That means customers pay $793 on average for a $325 loan (the study assumed a $52 fee and that the loan was "flipped" to a new one nine times).

Why it Matters:

If you've ever been short at the end of the month, you know how nice it would be to move payday up a few days now and then. That's why the payday loan business is so popular. But it's also one of the most controversial businesses out there, especially in an era when so many Americans are struggling to get by and credit is hard to access.

There are conflicting opinions on whether payday loans are a way for consumers to keep their heads above water or are predatory businesses that exploit the poor or certain ethnic groups. And some people take several payday loans from different lenders, which can exacerbate the problem. The payday lending business's main value proposition, however, is that it is an alternative to bank overdraft fees, returned-check charges and late fees, which have gone up at many banks since the financial crisis.