Misconceptions of a Payday Loan
Posted on February 19, 2007
Filed Under Finance
Payday Loans are often compared to ‘loan sharking’ minus the part where you get your arms and legs cut off if you don’t pay back. You often hear the words like usury, or exploiting the poor, uneducated and the unemployed. These are just some of the misconceptions of a Payday Loan. For those who don’t know what a payday loan is, it is short term loan that is typically paid back within two weeks, or the next payday of the borrower. Fees are applied usually to every $100 borrowed. These fees can range from $15 - $40.Â
The purpose of this entry is to clear up some of the negative views and to educate the general public. The Payday Loan industry is not about exploiting the poor or unemployed.  A customer cannot take out a loan unless they are actively employed and receiving income. Most companies do not accept customers who receive income through benefits or pensions.Â
A customer satisfaction survey, sponsored by CFSA in 2004 was conducted and they found that 69% of Payday Loan customers have a household income above $25,000 a year. 52% are in the middle income group (25 – 50K). It was also found that 58% of users have at least some college education and 1 in 5 have a university degree. These are just some of the numbers that the media does not like to publish as a 650% interest rate, makes much of a better story.Â
The most common complaint of payday loans are its interest, what banks like to call it. But for Payday Loan providers, it is the administration cost of issuing a loan, also called fees. Â To the average Joes, an interest rate of 650%Â may be ridiculously high compared to traditional banks. But let me shed some light on this.Â
Supposed that the total fixed cost of providing a loan is $50.00, it doesn’t matter what the loan amount is. Say you borrowed $1000 from a traditional bank that has a maturity date of 1 year. In order for the bank to cover all of its cost ($50) of issuing you the loan, they would need to charge you an APR of 5%.  However as the loan size and maturity decreases, the equivalent interest charge must rise up in order for the bank to cover all of its cost. If for example you chose to borrow $200 from the bank and you want to pay it back in 2 weeks, the banks would need to charge you an interest rate of 650% to cover the cost of issuing a loan, which in this example, is still $50.00. (200 x 650% x [2/52 weeks] = $50.00).Â
You can see that it is not fair for the media to compare payday loan interest rates to traditional banks.  Yes, some may argue that the fees are extremely high for the principal amount borrowed. Many articles will suggest that it’s a better alternative to use the bank, however most banks will not consider a loan application for $500 and even if they did, the process to acquire a loan is a nuisance and an inconvenience. Some of these customers have also been turned down by their banks due to credit. Also keep in mind that the lenders are taking a big risk. I can’t even imagine what their bad debt is like.
The best way to deal with Payday Loans is to understand them. They are meant to be used as a short term and not a long term financial solutions. You don’t take cabs to travel from one state to the next. You use the cab to get you from one side of the city to the other. Similar to payday loans they need to be used that way, short term solutions in a convenient way.  Customers need to understand this concept and need to know that they have options. If you are in the market to shop for the right payday loan, here are some tips you can use. Â
- Before you borrow money, make sure that you fully understand the fees and charges that are applied to the amount of money you want to borrow, as well as the application process and payment details. The more you know and understand the better.Â
- Stay away from companies that offer roll-overs. This may be tempting because you only have to pay for the fees and not the principal. However you may put yourself in a habit of doing this every two weeks. A two hundred dollar loan that could off cost you only $50 would have cost you $1200 after 1 year.
- Make sure that you only borrow what you can afford. This means that when its time to pay back the loan, make sure you have enough cushion to help you get by until the next pay period.
- If unexpected or emergency expenses come up which may require you to borrow a larger amount or subsequent loans. Make sure that your subsequent loan amounts are smaller than the previous one. Work your way back down to a position where you will have enough cushion to help you get through until payday.
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