Anyone who’s ever found themselves overextended on debt knows what a precarious financial situation that can be. When unexpected costs pile on top of existing debt, it can push a borrower’s finances over the limit. That’s when it may be tempting to take out a payday loan.
The Consumer Financial Protection Bureau defines a payday loan as “usually a short-term, high-cost loan, generally for $500 or less, that is typically due on your next payday.” Essentially, payday loans — also known as cash advance or check advance loans — are designed to cover sudden expenses while borrowers are in between paychecks.
Here’s how payday loans work:
- You visit a payday lender and agree on an amount.
- You write the lender a post-dated personal check for the said amount, fees, to be cashed on a specified date. On average, the typical term is about two weeks.
- When that date arrives, the lender cashes the check.
Simple enough. But if you don’t have enough money to repay the lender on time, then interest kicks in. Payday loans usually involve very high annual interest, or APR (annual percentage rate). According to the CFPB, the typical two-week payday loan comes with a $15 per $100 finance fee. Sounds like a 15% interest rate, which doesn’t seem too bad, right? Think again. The personal finance experts will tell you that the annual percentage rate on that “two-week” loan is nearly 400%.
And what happens if you can’t pay the loan back in two weeks? Many payday loans “roll over,” so in two weeks you’ll owe even more. And so it goes.
Whether you’re covering a sudden expense or paying down existing debt, most personal finance experts will tell you payday loans should be an absolute last resort. There are plenty of alternatives, including payment plans, credit card hardship programs, and balance transfer credit cards.
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How payday loans and balance transfers stack up
Let’s say Alex owes $1,000 in credit card debt. On the week he plans to start paying it off, his car breaks down, and repairs cost another $1,000. Now Alex has to deal with two costs. How to pay?
The choice between a payday loan and a balance transfer gives him these options:
- Take out a payday loan and commit to paying off the $2,000 he owes, fees, in a short period of time
- Put the additional $1,000 for the car repairs on his credit card debt, then transfer the combined $2,000 to a balance transfer credit card with 0% introductory APR, and pay it off bit by bit over time
At first glance, the payday loan may seem like the better short-term option. But here’s what happens in either scenario:
|If Alex Chooses…|
|Payday Loan||Balance Transfer with 0% Intro APR|
|If Alex Misses a Payment…|
|Payday Loan||Balance Transfer with 0% Intro APR|
APR and fees
It’s important to note that interest is not separate from a loan’s APR. Interest is an additional cost paid for the right to borrow money in the first place. (And it’s usually how the lender makes money.) APR is short for Annual Percentage Rate, and it refers to the total cost of a particular loan, including fees and any other extra costs. While interest and APR aren’t one and the same, interest contributes to a loan or debt’s overall cost and thus is considered part of its APR.
Many balance transfer cards offer an introductory APR of 0% between 15 and18 months, and typically a variable 10-25% afterward. So if Alex manages to pay off his $2,000 balance transfer within the intro APR period, he’ll be able to do so without incurring any interest. If he doesn’t finish paying down his debt before the introductory APR period ends, whatever remains of the $2,000 balance transfer would be subject to higher APR.
Balance transfers often require a fee of 3-5% of the amount transferred, meaning that if Alex transfers his entire $2,000 to a balance transfer credit card, he would pay a $60 to $100 fee.
Because payday loans have to be repaid quickly, they’re designed with notoriously high APRs, again, averaging around 400%. Payday loan APRs can be fixed or variable depending on the lender, but typically debtors incur fees of $15 to $30 per $100 borrowed.
If Alex agrees to a payday loan of $2,000 the finance charges put the actual cost of the loan at around $2,300. Since Alex has to take out a loan to cover his debt in the first place, it’s unlikely he’ll have enough funds to cover the original amount, extra. If Alex doesn’t have the funds in his account by his next paycheck, his payments are considered delinquent, and the payday lender will begin charging interest with a high APR.
Once Alex is late, his payday loan lender may offer a “rollover” fee, also known as a renewal fee. Rollover fees typically cost around $45 and simply delay paying back the loan. Payments do not contribute to principal or interest owed. So, if Alex were to pay a rollover fee on his payday loan, he’d be paying an extra $45 to extend the due date until his next payment period.
As with any other credit card, balance transfer credit cards require a credit check before approval. The better Alex’s credit is, the more a chance he’ll have of being approved.
Payday loans often don’t require a credit check before approval. Instead of using FICO or other established credit score institutions, lenders utilize a custom creditworthiness score based on the information borrowers provide.
Even if Alex has bad credit, he might be able to get a payday loan, no questions asked. But if Alex manages to pay off his payday loan, his credit score might not go up. If he’s delinquent, his score might go down. Some payday lenders report late payments to major credit reporting agencies.
Other debt consolidation and management options
In addition to balance transfers, alternative methods of paying off debt include:
Many credit card issuers offer financial hardship and payment assistance programs, including Discover and American Express. Before you consider a payday loan, call the Customer Service number for your credit card issuer and see if you can negotiate a lower interest rate or extended payment plan.
Debt consolidation loan organizations
If you have debt with multiple lenders or creditors, consider a debt consolidation loan company.
These organizations allow borrowers to lump different streams of debt together, often with a lower interest rate. You’ll have fewer debts to worry about and a chance to improve your overall financial health.
Payday loans or balance transfers: Which is better for me?
At first glance, payday loans might seem like a quick and easy solution for borrowers to receive emergency funding in a pinch. However, high APRs and fees, combined with a short repayment term, can make it all too easy for borrowers to get caught in a debt trap.
Balance transfers, on the other hand, offer a less risky way to manage credit card debt. If there’s an emergency, using a credit card and then transferring the debt to a balance transfer credit card to pay it down monthly is a viable option.
A balance transfer card allows you to pay down debt gradually without a lump sum coming due in a matter of weeks, and making timely monthly payments is a great way to rebuild your credit.
Payday loans should only be used once you have exhausted every other option. If you do take out a payday loan, prioritize that debt above all others, and pay it off immediately.