Payday loans are short-term loans for typically under $1,000 with very high interest rates that are designed to be repaid from your next paycheck. Advertised as a short-term solution for unexpected expenses such as vehicle repair or an upsurge in utility bills, payday loans are regularly used to deal with recurring expenses or to pay off credit card debt.
You may have read that last sentence and wondered, ‘Why would anyone take out a payday loan to pay off credit card debt?’
Well, imagine being in the hole $25,000 because of credit card debt without a formal understanding of how interest rates work. You could be facing a monthly minimum payment upwards of a few hundred dollars. Most people care about their credit score, and you’re one of them. But you found yourself in a situation where you’re no longer able to keep up with a surging minimum monthly payment and are in jeopardy of having your credit score take a hit due to missed payments. Even worse, you could be marked as delinquent and just received a final notice to either make a payment or have your debt sent to collections. What do you do?
Remember, for this thought exercise you lack a formal understanding of how interest rates work.
For example, a borrower from Alabama who participated in a Pew case study stated: “Because the interest on . . . some credit cards [is] 23.99 percent. So if you go charge $300, and then you don’t pay that $300 off at the end of the month . . . they’re going to tack that 23.99 percent on to it, so you’re going to still be paying more than you would if you had to [get a payday loan].”
He was about half right, the interest rate for a credit card is about 23.99%. However, that interest rate is expressed as an annual percentage rate. Meaning the monthly interest rate is approximately 2%.
However, if you are under the belief that 23.99% is going to be tacked on to your debt at the end of every month, then it’s completely understandable that you would look at a $15 fee per $100 borrowed as 15% APR and thus attempt to pay off your credit card debt using a payday loan. So before you apply for a payday loan, there are some things you should know.
Payday loans: what to know before you apply
Before applying for a payday loan, you may want to familiarize yourself with a few basic finance terms to wholly understand the terms and conditions of your loan obligation.
Finance terms you should know:
- The principal – the amount you initially borrow
- Repayment term (# of days) – the time window in which you must repay the loan
- APR (Annual Percentage Rate) – the annual interest rate charged for borrowing a given amount. APR stands for annual percentage rate, however, with monthly compounding the effective annual rate (EAR) is a little bit higher than APR
- The total cost – the total amount that you owe including fees and interest
Consider budgeting and reducing your variable monthly expenses
Whenever you’re faced with a substantial amount of debt, overwhelming monthly expenses ― or both ― cutting back on expenses and creating a strict budget is a good idea. According to Pew, 81% of payday loan borrowers say they would cut back on expenses if faced with a cash shortfall and payday loans were unavailable.
If you need ideas on where to get started, here are some quick tips for cutting back on monthly expenses:
- Cut out the lattes
- Shop in thrift stores
- Bring a packed lunch to work
- Avoid the bars
- Evaluate other phone carrier options
- Turn your lights off when you leave the room
- Replace your old light bulbs with CFL or LED bulbs
- Use coupons and shop for deals
- Carpool to work
- Lower the temperature on your hot water heater
- Stop using cable
How are payday loan interest rates calculated?
To calculate the APR for your payday loan, all you need is your loan amount, the initial/rollover fee amount, and the number of days in the loan term. From there it’s simple arithmetic.
Here’s an example to help you out.
Step 1: Divide the fees by the loan amount.
$56.25 / $375 = 0.15
Step 2: Multiply the answer in Step 1 by the number of days in the year.
0.15 x 365 = 54.75
Step 3: Divide the answer in Step 2 by the number of days in the loan term.
54.75 / 15 = 3.65
Step 4: Multiply the answer in Step 3 by 100.
3.65 x 100 = 365% APR
Things to keep in mind when using an online payday loan calculator
- It’s only an estimate of the total costs; actual costs may vary depending on the terms and conditions of the loan
- The costs are determined based on the information that you enter
- You should not make decisions solely based on an online loan calculator
- Hidden fees, fees, and rates vary depending on the state you reside and may change frequently
- Ask your lender about potential fees that are not included in the calculator
How does an online payday loan work?
Online payday loans are similar to their storefront counterparts in that you submit an application or loan request form. You will typically need to provide information about your earnings, bank information, workplace, etc. Loan amounts vary as described above. If you’re approved for the loan, which is normally the case, you can receive cash as soon as one business day or even in some cases the same day.
The key thing to keep in mind is that online lenders use an Automated Clearing House (ACH) network to directly connect your bank account to their payment system. Meaning as soon as your loan term hits they have complete authority to withdraw the money directly from your account. This is why it’s so important to understand the terms and conditions, fees and rates, and your monthly budget before signing up for a payday loan.
If you took out a payday loan and have any questions about payday loan debt consolidation please give us a call or make a request for a free consultation.