Why Payday Loans Cost More
Payday loans are coming under increased federal scrutiny and recently New York prosecutors indicted a payday lender for usury. Technically, usury is the charging of any interest on a loan – even as little as one percent. However, in today’s terms it is typically redefined as “exorbitant” interest.
So what does exorbitant interest mean? The Merriam-Webster dictionary defines it as “going far beyond what is fair reasonable or expected.” So in actuality the exact level of the interest rate is debatable. So what is a fair and reasonable interest rate for a payday lender to charge?
What Is an Interest Rate?
Basically an interest rate is the cost of a loan. If borrowers have excellent credit scores and high-paying jobs, they usually qualify for the lowest interest rates. In other words, they spend less to borrow money than an average or bad credit borrower.
If you really think about it, it makes sense. A credit report shows they are a good credit risk because they pay back loans on time. This is why they have a high credit rating. On the other hand, borrowers with bad credit have suffered one of two things. They either have an inaccurate credit report — which they can dispute and correct — or they’ve had trouble paying back loans or other bills.
Now many times this may be out of their control. For example, they had to get necessary medical procedure, which cost more than they could afford. Unfortunately, they couldn’t pay the bill and the unpaid bill was reported to the credit bureaus, harming their credit score.
In the past, you could explain these types of situations to your local bank and still get a loan – but not any more. As banks have consolidated, lending decisions have become automated. A computer looks at your score and gives you a thumbs up or down. It also calculates an interest rate based on how “risky” you are as a borrower. If you have great credit your loan costs less, but if you have poor credit it costs more.
Are Those With Bad Credit Being Overcharged?
Not necessarily and here’s why. The lender charges them more because they are classified as a bigger risk, meaning past history has shown they may not pay back their loan on time or at all. Now they still need the money for a financial emergency and the lender has the money – and knows that many of the borrowers will pay on time and not default. The problem is they can’t identify that beforehand so they charge more for the loan. The higher rate offsets the cost of the loans that go bad or unpaid.
Is this a perfect system? No, but it is how almost all lending works – home loans, car loans, personal loans, etc. It may help to think of an interest rate as a price tag. In other words, you can buy $100 for $15 or you can buy $500 for $75 (15 x 5).
What Payday Borrowers Are Paying For
Now let’s take a step back from the “payday lenders charge exorbitant annualized interest rates” criticism and look at exactly what a payday borrower is “buying” beyond just the amount of the loan.
• Easier and Faster Approvals
• No Credit Checks
• Faster Access to Cash
• Time Savings
Have you ever applied for a bank loan? It is a very long and tedious process, especially if your credit is compromised. You have to provide a lot of documentation, including credit reports, pay stubs and maybe even tax returns. The bank may also require verification of all the documents you present – and you’ll have to complete a detailed application. You also need collateral to back many loans.
If you can’t do this, you may not have a lot or any other options. You can still find the money you need, but you’ll have to pay more for it. You’ll also be paying for a faster and easier approval, and the right to get a loan when you credit is subpar. The application process takes a couple of minutes and you usually only provide job (paycheck stub) and bank account information.
Now, if you have great credit and all your important documents at your fingertips, you should apply for a bank loan first and you’re likely to get the best rates and terms. Or if you have an excellent credit score, you might also find a credit card. A payday loan is probably not a necessary option for you – unless you need the money in the next 24 hours. The other options take at least a week or two.
But if not, it may be worth the increased cost of the loan to get cash now for your financial emergency. I don’t know your specific situation, but you do and you can easily figure out if the cost of a high-interest loan is better than the costs of the alternative.
Are you about to get an overdraft fee or have your power cut off? Obviously, those are expensive situations. Overdrawing your bank account by $10 can cost you three times as much – or $30 per overdraft. Having your power disconnecting is even more costly – you may have to pay your entire bill, a reconnection fee, and a deposit to get it back on. A $200 bill can easily turn into $600 ($400 past due; $200 deposit). In the meantime, how much will you spend going to the Laundromat and out to eat while the power is off?
Unfortunately, these valuable benefits are often overlooked when critics talk about doing away with payday loans. Why? Most don’t face the same challenges or financial difficulties as those who use and need short-term loans for emergency financial situations. They don’t understand how these loans actually save consumers money compared to their other alternatives.