What befalls 80% of payday loan borrowers, and how you can be in the other 20%?

Payday loans are an established concept but have only truly gained traction in recent years, especially within Western nations. A generic search referencing loans or finance-related terms will almost undoubtedly return at least several advertisement hits promoting payday loans, and such marketing efforts are permeating real-world markets as well. Usage of payday loans is indeed on the rise. In the United States alone, loaned funds comprise an estimated $7.4 billion of annual retail expenditure.

Often criticized for not only perpetuating but also exacerbating urban poverty within vulnerable populations, payday loans regularly come under fire for intentionally practicing predatory marketing on low-income communities, whom are most prone to requiring such loans. Indeed, the payday lender industry is notorious for being a veritable breeding ground for a myriad of scams, fraudulent and fly-by-night operations. With even legitimate lenders employing methods that are questionable at best, it is understandable that most governments have restrictions against or outright forbid such practices in order to safeguard vulnerable groups.

Granted, there do exist proponents to the payday system, but it should be noted that the majority of said proponents outright own stakes or possess interest within the industry. The general consensus holds that payday loans are largely detrimental and pose significant risks to borrowers, especially to the uninformed. The payday system features an array of terms and conditions that quickly and harshly punish late repayments, and generally disservice even punctual individuals.

Here, we’ll go in-depth regarding the most common pitfalls payday lenders are wont to employ, how to identify and avoid them, and the recommended ways to manage one’s finances within the private lending market.

What are payday loans?

Payday loans are typically small, short-term loans with loan periods usually going no further than a month – or, just long enough until one’s next payday, hence the namesake – and are characterized by expedited approval periods, tolerance for low credit scores and in return, extremely high fees relative to their mainstream counterparts. Indeed, whereas traditional bank loans feature an annual percentage rate (APR) that varies within the low-to-high two figure range, APRs of payday loans commonly average at around 400%. Accounts of borrowers shouldering APRs of 2000% or more are less common, but shockingly, not unheard of.  A popular and oft-advertised variant of the payday loan is the same-day payday loan, a form of payday loan with approval periods of within 24 hours, often with the omission of credit checks altogether.  

From observing the base qualities of payday loans, it is quickly apparent which demographic would be most prone to taking up such loans. Namely, those who are in a financially unstable position so much so that they require external funds in order to make ends meet until the next paycheck. In an ideal world, payday loans would function as an easily accessible source of financial aid that those in a temporary rough spot can utilize to tide them over. However, the true nature of payday loans is far less altruistic and can quickly turn borderline predatory.

In the following section we’ll delineate the most common dangers of payday loans that borrowers should be wary of.

 What happens to the 80%

The principle rule to remember of all businesses is that they are profit-driven by nature. Money lenders are not exempt to this rule, rather, due to the nature of their transaction-based revenue, it can be said that they more readily embody this principle. A prudent borrower should always be aware of this fact, and assume that whatever deals and terms being put on the table have been carefully calculated to work in the house’s favor.  With this understanding, it is much less likely for a borrower to be caught off-guard by unfavorable terms.

The primary and most often promoted aspect of payday loans is their promised same-day approval period that is usually achieved by omitting the credit check stage. Allegedly, payday lenders do not discriminate borrowers based on credit scores and offer an accelerated rate of approval that dwarfs the usual day or even week-long period that most banks require. Sadly, when a deal sounds too good to be true, it usually is. Lenders may be quick to promise same-day approval but reality often arrives contrary. What actually occurs is a gross liberty being taken with semantics. When a prospective client applies for a loan, it usually is technically approved by the lender on the same-day, so he has, in writing, fulfilled the stated promise. However, the time taken for funds to actually be transferred and materialize in the borrower’s account can take anywhere from several days to upwards of a full week. Within this chronological discrepancy, lenders more often than not are actually conducting the very credit check they were supposed to skip, and in so doing, are able to discern the risk level of the borrower and accordingly raise interest fees to the maximal appropriate level in response.

Indeed, it is standard for fees to be pegged to a client’s credit score; this practice is common even to banks. Whenever a financial institution agrees to loan any sum of funds to the client, there is always the inherent risk that said client may default on payments and this constitutes a potential loss to the lender. A good credit score is an assurance that the borrower will make good on repayments as agreed, whilst the converse is true for a bad credit score. In essence, accepting clients with bad credit scores directly translates to the lender accepting a greater level of risk of loss with every transaction. By virtue of this principle, lenders will hedge their losses accordingly by raising fees against prospective clients who are deemed higher-risk – that is, clients with a poor credit score. This is a perfectly sound and rational response that a business would take in response to elevated risks and payday lenders not only understand but adopt this.

For a payday lender to see their claims through and actually omit the crucial credit check from a prospective client, it would mean acknowledging the acceptance of a significantly elevated degree of risk by going in blind. Consequently, in accordance to these heightened levels of risk, payday lenders will raises their fees in order to hedge their losses in very much the same way a bank would – the key difference being the accepted risks being far larger in the former’s case. This is the mechanism that produces the astronomically daunting APRs that payday loans are notorious for. Some payday lenders will go a step further and demand collateral in exchange for larger loans and the fronted collateral is usually disproportionate to the actual value of the loan (i.e. a car being put up as collateral for a several thousand dollar loan). These measures are harsh but fair if the majority of payday lenders actually provide the touted services that these fees were exchanged for. In reality, this is an exception rather than a rule, and borrowers frequently wind up unknowingly shortchanged.

These issues are further compounded by the lenders’ propensity to impose heavy late repayment fees should borrowers fail to be punctual. While an objectively fair practice, it becomes much more sinister in nature when we again consider the demographic that payday loans are aggressively marketed towards. Indeed, the real revenue for payday lenders lies in taking advantage of the poor financial straits of their most prospective clients, anticipating their failure to make repayment, and then legally confiscating their remaining assets.

Even scarier is the fact that even if one were to consider the ideal situation wherein funds are repaid punctually, it still leaves the borrower worse off compared to his original position. A $100 dollar loan under the standard 400% APR calls for an eventual $400 to be repaid, leaving the borrower $300 short. If said borrower is indeed from an economically vulnerable group, this gradual leeching of funds will only contribute towards exacerbating his poverty and necessitate further loans in the future. Further loans sink this person further lower in debt, perpetuating a vicious cycle of negative feedback. Cases of single borrowers taking up loans from multiple payday lenders simply to pay off prior loans are not uncommon, and rarely end well for the poor client

Considering the sheer myriad of ways a payday loan could backfire upon the borrower, it is no wonder that such loans are commonly denounced and justifiably vilified by judiciaries and societies alike. It is incredibly telling when one’s business model is regularly criticized by governments, moreso when at best, it leaves one’s clients suffering a distinct loss.

A word about scams

An even more worrying prospect to consider is that the above deals with legitimate payday lenders. However, as outlined in the introduction of this article the private lending market is permeated by no small number of unscrupulous scammers and frauds. Some of the most common methods they employ are listed here.

Hidden/superficial fees

An upfront lender will usually lay out the full set of terms and details pertinent to the loan during initial negotiations and will be readily able to explain the rationale for each listed fee. In the event that terms do indeed change afterwards, they should be explicit in mentioning and bringing attention to such modifications and will be able to account for them accordingly. Frauds tend to lure prospective victims in by presenting unnaturally favourable terms and then covertly tacking on additional fees, especially to the fine print, that clients may not be aware of before signing the final agreement. When asked to state what these fees are in exchange for, they will likely be able to provide only vague or weak explanation. This is to be expected, as most of these fees often serve no purpose other than simply to extract more from the client. Be wary for anything vaguely listed such as “administrative fees” or similar.

Identity theft

Since many payday lenders claim to bypass the credit check procedure, there should be no discernible reason for them to require your social security number (SSN). At most, they may require the last 4 digits of your SSN to ascertain the validity of your provided personal particulars. 

Be extremely wary should any lender request for your SSN in its entirety, it could very well be a prelude to identity theft. In 2013 alone, identity theft cost Americans a staggering $24.7 billion as more and more individuals fell victim to phishing scams and related crimes. For a sense of scale, household burglary, vehicular and property theft combined managed a mere $10 billion in comparison

Fly-by-night operations

Fly-by-night operators can masquerade as any form of business that may be privy to clients’ assets. Payday lenders form a perfect front for such scammers considering the common practice of fronting collateral in return for larger loans. As the fronted collateral often out-values the issued loan, scammers usually still find themselves profiting overall. In even more brazen cases, frauds might even abscond with the collateral without ever providing the promised loan at all.

How to remain in the 20%

Payday loans certainly appear a risky proposition to say the least, even when carefully managed they nonetheless remain a no-win scenario to the borrower – a literal financial zugzwang. There do remain methods with which one may avoid or mitigate the risks associated with payday loans

Seek alternatives

Thoroughly consider all available options before you seek out a payday loan. Do you really even need whatever the loan is supposed to be financing in the first place? If so, are there truly no other available avenues from which you may obtain funds? Your credit score may not be as terrible as you think, check with your bank if there are any loan options you might remain eligible for, even the steepest rates offered by banks pale in comparison to the daunting fees that payday loans demand. 

If your credit score truly is a veto factor, consider the wide variety of alternative loan methods that you could take advantage of. Peer-to-peer (P2P) lending is a form of social lending that has many of the benefits payday loans offer, and with considerably lower risk and fees. Consider also personal loans from family and friends, while a tricky social situation to navigate, it is nonetheless inherently less risky than payday loans. Check also with your local government’s office or city hall to inquire if there are any government loan schemes that you may be eligible for, especially if your loan is for civil amenities such as education or housing.

If all else fails, keep looking through available private lenders. They may be rare, but a number of these are not payday lenders and do run a genuine and reliable business.

Keep it a one-time affair

In the event that you truly have no other option than to take up a payday loan, be sure to limit usage and to keep it an isolated affair. Remember that even at best, payday loans will eventually put you in a worse-off position so this should only be attempted when you are very sure you are able to make repayment and are in a strong enough position to accept the eventual loss. The worst thing you can do is to utilize payday loans on a long term basis and subject yourself to a cycle of penalties.

Rebuild your credit

Finally, it may be a cliché and almost banal stance to take, but prevention truly surpasses cure. It is never too early to begin improving and rebuilding your credit score.

Responsible usage of secured credit cards, cosigners and retailer programs will positively contribute to your track record. It is no doubt a gradual and difficult process but as your score improves you’ll gradually be able to borrow at much more reasonable rates with far more loan options available to you. Given enough time you’ll be eligible for enough options such that inferior choices such as payday loans need not ever be considered. The time and effort invested will be worth it.

Conclusion

Payday loans are indeed a financial Pandora’s Box and given a choice, wise is the person who avoids such lenders entirely. It is the writer’s sincere intentions that this article has benefited you in any degree at all, and has been of aid to your financial understanding and decision making. Please safeguard yourself and your loved ones from the numerous pitfalls of payday loans.