Editorial Policy

How to Avoid the Payday Loan Trap

Allie Johnson

April 8, 2013

Payday loans are often advertised as short-term debt that can help you through an emergency. But that's not how consumers are using them.

The 12 million U.S. consumers who use payday loans every year are drawn to the quick relief from a cash crunch. Yet many later find the loans to be much more of a financial burden than they bargained for, according to a February 2013 survey of more than 700 payday loan borrowers conducted for the Pew Charitable Trusts.

Here are some of the survey findings that challenge the myths surrounding payday loans — and some ways you can avoid the payday loan debt cycle:

Payday loans aren't just for emergencies. Payday loans are often portrayed by the industry, policymakers and consumers as a way to get your hands on cash quickly in an emergency; for example, the car breaks down, the toilet stops working or a family member has to go to the doctor. But the survey showed 69 percent of first-time payday borrowers used the money for routine expenses, such as rent, utility bills, making the minimum payment on a credit card or buying groceries. Only 16 percent used the loan to cover an emergency, such as a car repair or illness.

“What we kept hearing from people was, 'I used a payday loan to cover my bills — to pay the rent, pay the utilities or make a minimum payment on a credit card. I'm short on cash all the time. I'm struggling,'” says Alex Horowitz, research manager at Pew Charitable Trusts.

Payday loans can last a long time. Payday loans are advertised as two-week loans, and that appeals to borrowers who want to avoid getting trapped in ongoing debt, according to the survey. “They are very familiar with debt and not eager to take on more,” the report says about these consumers.

But the average loan amount of $375 ends up costing $520 after finance charges and lasting five months, according to the survey. That's because many consumers can't afford to pay off the whole amount, so they renew the loan over and over again, paying additional finance charges each time, Horowitz says. That's because the typical borrower can afford to pay about $100 in a month, but owes $430, including the loan amount and fees.

“They are re-borrowing the same money again and again,” Horowitz says.

Payday loans don't prevent checking account overdrafts. Payday lenders sometimes describe the loans as a way for consumers to avoid even bigger finance charges from bounced checks and overdraft fees. But paying off payday loans often requires borrowers to overdraw, meaning they end up paying hefty fees to their bank, along with the payday loan charges. In fact, half of payday loan borrowers surveyed had a bank account overdraft in the past year, and 27 percent of borrowers had an overdraft triggered when a payday lender automatically withdrew funds from their account.

Borrowers need to come up with extra money get out of a payday loan. The survey found that 48 percent of payday borrowers ended up having to get their hands on a lump sum to get out of the payday loan cycle. In fact, the survey showed that consumers got money via methods they could have used to avoid the loan in the first place, Horowitz says. One out of six borrowers has used a tax refund to get out of the loan, and borrowers also have cut back on regular expenses, received loans from friends or family, held a yard sale or pawned a personal possession, the survey shows.

How to avoid the payday loan trap
Are you are someone who has turned to, or thought about using, a payday loan to handle a financial shortfall? If so, here are some tips from a financial counselor on how to turn your situation around to avoid a payday loan:

1. Meet with a credit counselor. If you're not sure where you can cut expenses or how to come up with a budget that works for you, meet with a credit counselor for free, says David Jones, president of the Association of Independent Consumer Credit Counseling Agencies. The counselor can review your bills, help you come up with a budget and brainstorm ways to deal with a financial emergency.

2. Resist the payday loan temptation. A payday loan might not look like such a bad deal if you're desperate, but watch out. “It's a very dangerous thing to do, and it's the last thing you ought to do in most cases,” Jones says.

3. Find ways to cut expenses.Credit counselors often find that consumers who are pressed for funds have ongoing expenses that can be cut, Jones says. For example, many consumers in financial trouble have cellphone bills of up to $200 or more per month and cable bills of $150 to $200 a month.

“The new phones with data charges can be really bad – especially if your kids use the Internet a lot and you end up paying over-limit charges,” Jones says.

He notes that many families can easily cut cellphone and cable back to more basic services.

“It's amazing how counselors can help people find things that are relatively simple to cut,” Jones says.

4. Create a plan to pay off high-interest debt.Paying off high-interest credit cards or payday loans can free up money for bills and emergencies, Jones says.

“These debts will just eat up your disposable income,” Jones says. “Once you get rid of them, you find you can actually start to save a little bit.”

5. Start saving for emergencies.“Having a little buffer of savings is absolutely essential, especially for people living hand-to-mouth,” Jones says.

Some consumers resist doing this, so it's best to make it easy. That means starting small if necessary, Jones says.

If you get used to not having $5 or $10 a week first, then you might get used to not having $10 or $20 a week. You'll start to see your savings grow.”It's best if consumers can find a way to automate savings, either through having part of their paycheck deposited directly into a savings account or setting up an automatic transfer through their bank, Jones says.

As your financial situation improves, Jones says, you'll start to get motivated to improve it even more.

“You will start to see good things happen,” he says.