According to a report by the Federal Reserve, there are many positive trends in personal finance in America. In general, people are borrowing less and saving more, which is definitely a positive sign that we learned a lesson from the financial crisis.
However, I saw one statistic that is rather troubling. Over the past several years, the percentage of Americans who use payday loans has risen significantly. Just how many people use these dangerous loans, and what makes them so bad?
What exactly is a "payday loan"?
The name is somewhat misleading, because these loans don't necessarily need to be linked to the borrower's payday. The term "payday loan" refers to a relatively small, short-term, unsecured loan, and is sometimes also referred to as a cash advance loan or payday advance.
There is typically no credit or background check required, just a verification of employment and a bank account. In the traditional payday lending model, the borrower writes a postdated check to the lender for the full amount of the loan. The borrower is expected to repay the loan in person, or else the lender can redeem the check.
In recent years, the concept of an online payday loan has grown in popularity, which could explain some of the recent surge in payday lending. The borrower applies online, and then receives funds via direct deposit, and the funds (plus any interest and fees) are withdrawn on the agreed-upon date.
Growing in popularity
According to the latest Survey of Consumer Finances (link opens a PDF) from the Federal Reserve Board of Governors, the percentage of Americans who have taken out a payday loan over the previous year nearly doubled from 2.4% in 2007 to 4.2% in 2013.
Although this is still a low percentage on an absolute basis, it's way too much. Quite frankly, no one should take out a payday loan unless it is a last resort.
The alarmingly high cost of payday lending
Now, the concept of a payday loan isn't necessarily a bad one. After all, sometimes people need to pay for things a few days before their next paycheck arrives. The problem is how much some payday lenders will charge their customers.
Due to the short time frames involved, the real cost of these fees is somewhat hidden. Let's say you take out a $500 payday loan to be paid back in two weeks (14 days). If your lender charges a $60 fee for the loan, which is actually on the low end, it equates to 12% of the principal amount. On an annualized basis, this is an interest rate of more than 300%.
In other words, if you get a new payday loan for $500 every two weeks for a year, you'll pay more than $1,560 in just interest, even though you will never owe more than $500.
So it's no wonder that payday lending is illegal (or severely limited) in many places throughout the U.S. In fact, 18 states have either banned, or severely limited, the amount of interest that payday lenders are allowed to charge. In an extreme example, payday lending is specifically forbidden in Georgia and is actually a violation of racketeering laws. New York and New Jersey prohibit payday loans as well.
Other states still allow payday loans, but with specific terms. For instance, Oregon permits payday loans with a one-month minimum term and a 36% maximum annual interest rate, plus a $10 fee per $100 borrowed.
However, the other 32 states have all passed legislation authorizing payday lending with absurdly high interest rates. For example, Florida allows a 419% APR on a 14-day loan. Alaska is even worse, as borrowers can expect to pay an annual rate of 520%. And Louisiana allows for interest charges and fees that combine to produce a staggering 780% APR.
Avoid at all costs
Payday loans are about the worst place you could turn for your borrowing needs, aside from actually going to a loan shark or engaging in some other illegal activity. It's alarming that so many Americans turn to this kind of loan when they need some quick cash.
Bank loans, borrowing from friends and relatives, and even running up your credit cards are all better alternatives. Avoid these loans and their ridiculously high expenses at all costs, and over the long run you'll keep a lot more money in your pocket.