Poverty Trap: Payday Loans-An Expensive Answer To Your Cash-Flow Crisis
One of the most important aspects of becoming a
successful wealth-builder is learning to recognize and avoid what I
call poverty traps: behaviors and ways of thinking that sabotage our
ability to increase our net worth and build wealth. The poverty trap
I'm going to talk about today happens to be a costly way that many
people address their cash flow problems or unexpected, unplanned
expenses—usually because they are desperate or don't know any better:
Payday loans.
We've all
seen or heard ads promoting payday loans on billboards, on the radio
and television, on the internet, and even in the mail: "Get Cash Until
Payday—Fast!" The problem is that this is an unreasonably expensive
source of credit, which is why people who habitually use these loans
(also known as cash advance loans, check advance loans, post-dated
check loans or deferred-deposit check loans) are usually perpetually
short of cash, have weak credit scores, earn relatively low incomes
and/or have adopted a lifestyle that requires them to spend more than
they make.
Here's how it
works: You write a personal check payable to the lender for the amount
you want to borrow, plus a fee. The lender gives you cash in the amount
of the check, minus the fee, which can be a percentage of the check
amount or a charge for every $50 or $100 borrowed. The idea is that you
will cover the check on your next payday. However, if you decide to
extend or "roll-over" the loan, you pay additional fees for each
extension—the longer you take to pay back the loan, the more it costs.
So
what makes this a poverty trap? Let's say you write a personal check
for $115 to borrow $100 for up to 14 days. The payday lender agrees to
hold the check until your next payday, when you will redeem the check
by paying $115 in cash. The cost of this loan is $15—a whopping 391
percent annual percentage rate (APR)! (And I think a credit card with
an APR more than 14 percent is too expensive.) Roll-over the loan three
times, and you've just paid $60 to borrow $100. It sounds crazy, but
there are people engaging in this form of "money management" on a
regular basis.
Before
falling into the poverty trap of payday lending, consider the following
alternatives suggested by the Federal Trade Commission (http://www.ftc.gov/bcp/conline/pubs/alerts/pdayalrt.shtm):
- When shopping for credit or a loan, ask for the APR. Under the Truth in Lending Act, lenders must disclose this information, along with the finance charge, in writing. If you look for the option with the lowest APR, you'll find borrowing from a credit union, your employer or family or friends until payday will always be a better deal.
- Ask your creditors for more time to pay your bills. Even if they charge a late fee or raise your interest rate, it will probably still be cheaper than a payday loan, and definitely cheaper if roll-over fees are added.
- If you must use the services of a payday lender, never borrow more than you can afford to repay with your very next pay check, and still be able to cover your necessary living expenses. Constantly extending payday loans creates an almost addictive cycle of fees that can and will rapidly consume your income faster than you can earn it. It's virtually impossible and extremely costly to catch up.