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Payday loan companies have long been thought of as small and sometimes shadowy operations that target people who need cash quickly, but don’t have traditional banking relationships. However, many mainstream banks have recently entered the market, offering short-term loans to their customers at very high annual percentage rates.
Traditional banks usually don’t refer to this type of financing as a “payday loan.” They use terms like “direct deposit advance” and “checking account advance.” But customers should be cautious before getting any type of payday-style credit, regardless of the name.
The way these loans operate is that you’re first required to have direct deposit on a checking account that’s in good standing. You borrow money from the bank in advance of your automatic deposit, and then when your deposit arrives—usually from your paycheck—the bank takes the loan repayment along with an extra fee.
If you have direct deposit, this indicates to the bank that you probably have a job or other steady source of income, such as Social Security. In fact, a recent study from the Center for Responsible Lending (CRL) found that almost one quarter of payday borrowers are Social Security recipients. Having direct deposit gives the bank a sense of security in lending you the money you need.
The High Interest Cycle
A major problem with deposit advances, however, is that they’re much more expensive than other lines of credit. As an example, Wells Fargo offers short-term loans of up to $500, and charges $1.50 for every $20 that is advanced.
So if you borrow $200, you’d have to pay back $215 with your next direct deposit, which is usually within a few days or weeks. (These Wells Fargo loans are not available nationwide, but they are offered in more than half the states in the country). Other banks that offer similar advance deposit loans are US Bank and Fifth Third Bank.
The costs may seem minor, but according to the CRL, a fee of that amount with such a small loan length translates into an APR in the triple digits. In fact, the organization reports that these loans often have APRs as high as 365%.
For what it’s worth, banking groups do point out that a deposit advance is cheaper than a typical payday loan from a storefront shop. Those loans have been reported to be as high as 780%.
But the problem with payday-style loans isn’t just the high rate. Another issue is that unlike a long-term loan, which is usually paid back in increments, short-term advances have to be paid back in their entirety once you receive your direct deposit.
The CRL report determined that this payment eats up about 44% of a borrower’s next direct deposit. Few people canafford to have such a large chunk of money removed from their paychecks.So in order to pay their bills, these customers often feel forced to take out another loan from the bank, and pay more high fees, in order to maintain cash flow. This cycle can last several statement periods as banking customers fall more and more into debt.
Some banks gradually reduce the amount of credit available to zero dollars if the customer uses the service for more than six consecutive statement periods. However, if you are trying to get out of debt, getting a short-term loan at a high interest rate for any length of time can do little to help.
Few Customer Protections
There are a few safeguards in place for payday loan borrowers. The government's Office of the Comptroller of the Currency has advised that banks make sure customers fully understand the fees and risks associated with these types of loans, so there is full disclosure.
Also, the FDIC advises lenders to limit the amount of time customers use these expensive loans to no more than three months per year. But the CRL analysis found that loan borrowers continuously take out these loans for almost twice that length of time, an average of 175 days annually. That means they owe money on these high-interest loans for almost six months of every year.
Many states cap interest rates for small loans. For example, the state of Maryland doesn’t allow an interest rate higher than 33% for small loans. However, state laws may not supersede federal laws, and banks are federally regulated. It’s unlikely that rates for payday-style loans will drastically drop just because of state legislation.
Alternatives to Raise Cash
If you’re short on cash, instead of taking on more debt with a payday loan, it’s better to find another way to come up with funds. Here are better options for raising extra money:
For more advice on how to quickly come up with a cash cushion, read our article on How to Earn Extra Money.
Traditional banks are offering payday loans these days, but they’re not a good idea for cash-strapped borrowers. If you’re in a money crunch, look for other ways to boost your income so you don’t fall victim to a short-term loan debt trap.
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