Investment Glossary – Payday Loan

Everyone loves payday. Well, Ebenezer Scrooge probably wasn’t a big fan of it for most of his life, but eventually, even he turned the corner on that one. Unfortunately, payday loans are mostly bad news when it comes to how they affect your financial situation. They are short-term loans, typically in small amounts, that are required to be paid back upon receipt of your next paycheck, typically with a high fee required to borrow the money. Let’s look at the mechanics of how a payday loan works.

Suppose you were in the middle of winter and your heat went out for some reason. You call a technician to come out and fix your boiler, and when they leave, they give you a lovely bill for $400. And unfortunately, it’s a really bad time for you to have a bill for $400. You haven’t been able to build up a sizeable emergency fund, and your credit cards are maxed out because it’s just after the holidays and you’re in a tight spot. This is the scenario people often find themselves in when they turn to payday loans, largely because payday loans are often a lender of last resort for people who do not have money to pay for immediate expenses and are unable to borrow from other, cheaper sources to cover those expenses.

The process by which a payday loan functions is pretty simple. You go to a payday lender and request to borrow a certain amount of money – in this case, $400. The lender will want to see a pay stub to prove you are able to pay that money back once you next paycheck is sent out to you. Once confirming this, the payday lender will give you the money you requested ($400) and have you sign a post-dated check back to the lender for the $400 you borrowed, plus any applicable fees.

This is where the cost starts to add up if you have to resort to payday loans.

Suppose you are borrowing $200,000 for a mortgage to buy a home. The underwriting process might involve 100 hours of work by the lender to underwrite that loan, but if they charge $50 an hour in fees to underwrite that loan, your total underwriting costs are $5,000. If you don’t refinance the loan, then those are the only fees you pay for the life of your mortgage, which is typically 30 years. Yes, you do pay regular interest on the loan as well, typically at rates between three and six percent per year in recent years.

With payday loans, the amount you borrowed is significantly smaller. And while the amount of work underwriting the loan is significantly less than underwriting a mortgage, someone still has to meet with you and go through the process of setting up the loan. If it takes them an hour of work to do so, and they have to earn an hourly wage, and the company offering the loan wants to make money as well, then it’s no surprise that the fees for payday loans have to be incredibly high to satisfy those requirements. According to the Consumer Financial Protection Bureau, payday loans can cost $10 to $30 for every $100 borrowed.

So that means that in the case of a $400 loan, it is going to cost you anywhere from $40 to $120 to borrow that money – for less than two weeks. That also assumes that you don’t end up right back in the same situation down the road, needing to borrow the money again to make ends meet. It’s a situation that many people find themselves in, as the fees are so high that it ends up trapping people in a cycle that forces them to continue to take out high-interest payday loans in order to make ends meet.

In short, payday loans are ultra-high-interest short-term loans for emergencies, and likely should be avoided by most families unless there are no other options and significant harm will come to you or loved ones if you are not able to pay your bills.