Advocates have long criticized payday loans. They're often expensive, with interest rates over 300%, and cost more than a third of a borrower's next paycheck, according to research from Pew Charitable Trusts. The Consumer Financial Protection Bureau issued new rules, set to take effect in 2019, that address some of the risks involved in payday loans. But even with tighter regulations, there's still a need for quick credit. Twelve million people take out payday loans each year, according to Pew, despite their high costs.
Why do people take out payday loans?
Pew has conducted multiple surveys with payday borrowers. The organization found most often, people are trying to cope with a shortfall, usually a bill that's come due, said Alex Horowitz, senior research officer for Pew Charitable Trusts.
They're not necessarily looking for the cheapest loan, but rather the fastest and easiest to get, Horowitz said.
"They have a bill that's due typically right away, or may be overdue already, and they need to pay it," he said.
Payday loans are easy to get, since their lenders don't use stringent underwriting criteria. You might need show ID and proof of income, but few providers check credit history. And, if they do, a bad credit score rarely disqualifies you — which is often cited as a reason the interest rates and fees are so high. They're pricing, at least in part, for risk.
Payday loans were mostly illegal until the early 1990s, when many states loosened regulations governing payday lenders.
What are the alternatives to payday loans?
There are a few less risky ways to deal with a sudden shortfall.
• You can try to get a loan from a local credit union. These loans are often cheaper and easier to get than a loan from a traditional bank, though you have to be a member.
• You can negotiate the bill, either to lower the amount or arrange a payment plan. You can save a lot of money by haggling over your utility bills.
• You can ask your employer for a paycheck advance, though not every employer will accommodate you. Walmart recently gave all its workers the ability to draw on their paychecks early, the New York Times reported.
• As a longer-term solution, improving your credit can give you better options in the event of an emergency. Even with bad or no credit, you can often get a secured credit card. These cards work just like normal credit cards and allow you to build your credit score, but you have to put a security deposit down first, usually around at least $200 to $300. Still, having access to credit in the event of an emergency later on could be worth it.
Weaning yourself off payday loans
Many of the people surveyed by Pew also said they would pawn or sell something of value, find a way to delay paying the bill or borrow from family or friends, Horowitz said.
There's also a chance you can avoid borrowing money at all. Many borrowers also told Pew they stay away from costly payday loans by trying to cut back on expenses. There are time-tested ways to cut back on spending without feeling deprived, like focusing on the things you already have and getting rid of anything you don't need. You can also try budgeting methods like paying yourself first. These strategies are more effective over time, but, in the short-term, bills aren't always flexible.
A suboptimal alternative
In addition, payday loan customers usually have checking accounts - that's where their paychecks go, after all.
"These are not unbanked folks," Horowitz said. "Overdrafting a checking account is also an option."
One-third of people who overdraft their accounts view it as a way to borrow money, a Pew survey in December found. Of course, overdrafts often incur big fees, too, sometimes as much as $35 per incident. Plus, charges generally get tacked on every day you don't shore up the account, so overdrafting a checking account is also a costly option for short-term cash.
A payday loan by any other name
Payday lending is part of a $30 billion a year short-term loan industry that includes auto title loans, pawn shops, rent-to-own purchasing and subprime installment loans. They all carry risks:
Auto title loans: You can borrow money while placing your auto title up for collateral. You could risk losing your car if you can't pay the loan back.
Pawn shops: Similar to an auto title loan, only the collateral is some other valuable like jewelry. Again, you risk losing the item if you can't repay the loan.
Rent-to-own: When you can't afford an item you want to buy, some sellers allow you to lease the item, often furniture or electronics, with an option to buy down the line. This is usually more costly than buying it upfront.
Subprime installment loans: These are loans specifically aimed at people with bad credit. (Here's how to get a loan with no credit.) The terms are often longer than payday loans, but the interest rates can be just as high.
Know your rights
The CFPB issued its rules in October. They govern payday loans and auto title loans with terms up to 45 days. The rules require lenders make sure borrowers can repay the loans or limit the size of loans to $500. Lenders also can't make loans to people who have taken more than six short-term loans or been in debt for more than 90 days over a 12-month period.
However, the rules don't cover loans lasting more than 45 days. Lenders in many states have started issuing longer-term loans with the same high interest rates, Horowitz said.
Further regulation needed
Pew's research has focused on how to make payday loans more affordable rather than getting rid of them altogether, Horowitz said. Pew holds the payday lending law enacted in 2010 in Colorado up as an example. There, borrowers have at least six monthes to repay small-dollar loans in installments of around 5% of one paycheck.
The change has made small loans much more affordable, Horowitz said. Borrowing $400 for three months in Colorado cost about $120 in interest in fees, about four times lower than in states where payday lending is unregulated.
Horowitz said banks could offer small installment loans that would be even cheaper for borrowers, while still earning more interest than they would from credit cards. Banks have the size to process loans like these cheaply and profitably. As we said, many payday borrowers are already bank customers with checking accounts, so banks already have a relationship with them.
"The bank knows they're likely to be repaid and the loans are paid in installments over several months," Horowitz said.
Given that the average payday borrowers spends $520 in interest to borrow $375, getting access to cheaper small-dollar loans would save borrowers billions of dollars, he said.