This Is the Most Dangerous Type of Debt in America

There's never a good reason to take out this type of loan.

You’ve probably seen the commercials for them. They’ve usually got a catchy jingle, an actor who always seems a little too impressed with the company’s services, and promises that they are the stuff of dreams -- literally. Payday loans sound too good to be true because they are. These lenders masquerade as friends to hard-luck workers, but in reality, they have more in common with loan sharks than they do with your neighborhood bank.

Yet millions of desperate Americans turn to payday loans every year when they need some quick cash, many of them never even realizing just what they’ve gotten themselves into or that there might’ve been a better way.

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How payday loans work

Payday loans work just like any other loan. You complete the application process, the lender gives you the money, and you pay it back over time. The only differences between a payday loan and a personal loan, or other loan you get at your bank, are the loan term and the interest rate. Payday loans typically have short loan terms of only a couple of weeks and the loans are usually for small amounts -- $1,000 or less. 

But while the interest rate on a typical loan might range from 4% to 30%, depending on the type, payday loans can have interest rates of over 400%. All states have enacted rate caps that limit what a payday lender can charge, but many of these caps still favor payday lenders over their consumers. Texas, which currently has the highest cap, enables payday lenders to charge as much as 661% in interest, according to the Center for Responsible Lending.

To give you an idea of how much this costs, let’s consider a $500 payday loan with a two-week repayment term. With a 661% interest rate, you’d owe $699.04 in only two weeks. If you don’t have $500 now, is it likely that you’ll have a spare $700 in two weeks? No? Better take out another payday loan to cover the first. And on and on it goes until you start paying late, missing payments on your other bills, and getting harassed by debt collectors. Now you’re paying late fees too. And possibly non-sufficient funds fees if the lender tried to take the money directly from your bank account, and rollover fees if you need to push back your due date. For many, bankruptcy or death are the only way it ends.

So why would anyone sign up for this obviously terrible deal? The main reason is because payday loans deliver cash quickly and they don’t require a credit check, so individuals with poor credit can get loans here when they might not be able to get them elsewhere. But often what seems like a short-term solution turns into an even bigger long-term problem.

Alternatives to payday loans -- and what to do if you’ve already got one

Individuals seeking payday loans typically have two major financial issues that need addressing: bad credit and a lack of savings. If neither of these apply to you, then you definitely have better options. If you have plenty of savings, don’t take on debt unnecessarily. If you have good credit, seek out other types of loans, like personal loans, that have a more reasonable interest rate. 

But what if you have both? Or worse, what if you’re already caught in the payday loan cycle? I’ll be straight with you. Fixing that situation is not going to be easy, but there are things you can do. First, see if the payday lender is willing to let you set up an extended payment plan that lets you pay back the loan in installments over a longer time frame without accruing extra interest so you don’t have to keep taking out new loans to cover the previous ones. If you can do this, you might be able to get rid of the payday loan in a few weeks or months.

If your lender won’t allow you to set up extended payment plans and you absolutely don’t have the cash to pay back what you owe, consider seeking a paycheck advance from your employer. Some personal loans are also available to individuals with poor credit, so this is worth exploring. Interest rates are probably still going to be in the neighborhood of 30%, but that’s a lot better than 500%.

You could also look into debt settlement programs or credit counseling. Credit counseling won’t get rid of your debt, but it can help you come up with strategies to get yourself out of debt and avoid taking on more debt in the future. Debt settlement is where your lender agrees to write off the remainder of your debt if you pay a lower amount you can both agree on. You'll usually pay a fee for the debt settlement company's services and you could owe taxes on the forgiven amount. This typically isn’t good for your credit, but it might not make things too much worse if your credit is already bad. Bankruptcy is also an option if nothing else works.

Once you get rid of your payday loan, you must take steps to ensure you never need one again. Build up an emergency fund so you have money to cover unexpected expenses as they arise and work on improving your credit score. Sign up for a secured credit card. These are regular credit cards, but they’re targeted at individuals with poor credit and they require a security deposit, which is typically equal to your credit limit. Your card issuer reports your payments to the credit bureaus and this can improve your score if you pay on time. Should you decide to close your secured credit card in the future, the company will refund your security deposit, assuming you have no outstanding balance.

Avoid payday loans at all costs. If you find yourself unable to make ends meet or to cover emergency expenses, seek credit counseling and work to improve your credit and emergency plan. Taking out a payday loan might seem easier, but it’s just trading one problem for a much bigger one.

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