Managing Payday Loans and Other Tips for Avoiding the Debt Trap
Sharon Powell, Extension Educator — Family Resiliency
English | español
What do payday lending, check cashing, auto-title lending, and pawnbrokering have in common? They are all alternative financial services offered by entities other than federally insured banks and credit unions.
Payday loans and other alternative financial services, also known as “fringe” banking services, fill a gap in the mainstream financial system by providing small-dollar consumer loans with short, or no, waiting periods. Payday loans and similar services offer a lifeline to many individuals and families who need these services to make ends meet.
Unfortunately, the costs associated with payday loans and other alternative financial services are high and can lead individuals and families into an endless cycle of debt. Experts say the best course is to avoid using alternative financial services altogether, but if that’s not possible, strive to manage them to your advantage. Once you gain control over your “fringe” creditors, you can start taking steps to save money and create wealth for your family’s future.
Who Uses Alternative Financial Services and Why?
Unbanked and underbanked people are most likely to use alternative financial services as a way to make ends meet.
“Unbanked” refers to an individual, family, or household without a checking or savings account at a mainstream bank or credit union, while “underbanked” describes an individual, family, or household that has a conventional bank account — but also uses alternative financial services.
A survey conducted in 2015 by the Federal Deposit Insurance Corporation estimates that about 9 million households in the United States, representing 7 percent of the population, were unbanked that year. The same survey indicates that an estimated 24.5 million households, or 19.9 percent of the U.S. population, were underbanked in 2015.
People are unbanked for various reasons, including a poor credit history, little understanding of the U.S. banking system, language barriers, or because their incomes are too low or too unreliable to open an account. Still other working people do have a conventional checking or savings account, but must use alternative financial services because they have cash flow problems and little or no savings. As a result, many people turn to payday lenders and other fringe providers to get money quickly for emergencies and other unexpected expenses.
How Do Alternative Financial Services Work?
Here’s a closer look at four major types of alternative financial services, as outlined by the Federal Reserve Bank of Minneapolis and the Consumer Financial Protection Bureau (CFPB):
Payday loans. These are typically quite small consumer loans — usually $150 to $300 — backed by postdated checks or authorization to make an electronic debit against an existing account. The check or debit is held for an agreed-upon term, usually about two weeks or until an applicant’s next payday, and then cashed (unless the customer repays the loan or reclaims the check).
The cost of most payday loans (the finance charge) ranges from $10 to $30 for every $100 borrowed. Thus, a typical two-week payday loan with a $15 fee per $100 borrowed equates to an annual percentage rate of almost 400 percent.
If a payday loan customer does not have funds for a check to clear, the same process is followed to obtain an additional loan or extend the existing loan, commonly referred to as a rollover or renewal. This is where the cost of a payday loan can really start to snowball. CFPB statistics show that 1 in 5 payday customers end up taking out at least 10 or more loans, one after the other. With each new loan, the customer pays more fees and interest on the same debt, and he or she has fallen into the “payday debt trap.”
Check cashing. Check cashing outlets (CCOs) cash payroll, government, and personal checks for a set fee, usually ranging from 3 to 10 percent of the face value of the check—or $1, whichever is greater. CCOs typically offer additional services and products, such as money orders, wire transfers, bill paying, and prepaid phone cards. A growing number also are offering payday loans.
Auto-title loans. Like payday loans, these are small consumer loans that leverage the equity value of an automobile as collateral. An applicant must own the auto title free and clear — any existing liens on the vehicle cancel the application. Loan terms are often for 30 days, and failure to repay the loan or make interest payments to extend the loan allow the lender to take possession of the auto.
Pawnbrokering. Pawnbrokers provide financing on the basis of the value of tangible property brought to a store. Brokers typically charge a flat fee for a transaction and hold the merchandise for an agreed-upon period of time for repayment and reclaiming of property. Upon contract expiration, if the loan is not repaid or extended by an interest payment, the broker assumes ownership of the merchandise and can put it up for resale.
Take Steps to Avoid the Debt Trap
Manage Existing ‘Fringe’ Loans
It probably goes without saying that if you must use alternative financial services, you should manage them wisely. For payday loans, that means paying off a short-term loan immediately and not rolling it over. For auto-title loans, that means keeping up with payments.
Ironically, as noted by the Consumer Financial Protection Bureau, wise management of existing “fringe” loans might also mean using the alternative financial service that carries no long-term cost or penalty — pawning possessions. At best, you may acquire money in adequate time to reclaim your valuables, and at worst, the pawnshop will assume ownership of them. Either way, you don’t take on debt.
Seek Help Paying off Rollover Payday Loans
If you have accumulated a large debt to a payday lender by rolling over loans, explore ways to get help for paying off the entire debt. Check whether non-profit and faith-based organizations in your community that help eligible clients refinance payday loans. Such programs help clients pay off predatory payday loans, and these clients then pay them back, often with no interest or fees, over time.
Some employers, community groups, and non-profit organizations also offer advances or emergency credit to help pay off payday debt, as well as other debt. Check whether such programs are offered in your community.
Options for Managing Debt
Besides paying off any loans to alternative financial service providers, it’s wise to consider other options for improving cash flow, obtaining small amounts of money, and/or reducing expenses in order to avoid debt traps. The Consumer Financial Protection Bureau (no date) lists some of those options, including:
- Getting a credit card. If you have direct deposit or a stable credit history, you may be able to obtain a credit card through your bank. (Note: Stay away from deposit advances with your bank, though, which have the potential to draw you into a payday loan-type debt trap. For more on this specific topic, see the Consumer Financial Protection Bureau’s My bank offers a direct deposit advance or checking account advance. What is this?) You might also consider obtaining a subprime credit card. Although not ideal, subprime credit cards are still less expensive than payday loans. Pay off monthly credit card balances in full so you don’t pile up debt again.
- Negotiating with creditors. Try negotiating a smaller repayment amount at a lower interest rate with creditors. These steps will improve your cash flow and may allow you to start saving money for the next emergency that comes along.
- Applying for affordable payment plans with utilities. In addition to negotiating with creditors, obtaining affordable payment plans with utilities is a way to improve cash flow and may allow you to start saving money. Check with your local utilities to see if you’re eligible for such plans.
- Asking family or friends for help. Last, but not least, don’t be afraid to ask family or friends for occasional help with short-term expenses. To preserve personal relationships, handle the transaction in a business-like manner — Put the loan and plan for repaying it in writing, and of course, be prompt in your payments.
For more information, see the Consumer Financial Protection Bureau’s I need money now. Should I get a payday loan? What other options should I consider?
Create a Better Future
As you take steps to manage — and eventually stop using alternative financial services — your long-term goals should be to save money and build a credit score. If you have a checking or savings account with a mainstream bank or credit union, see if it offers secured credit cards or credit-building loans, and apply.
If you’re unbanked, it’s difficult to build credit, but not impossible. Check to see if non-profit organizations in your community offer help with reporting things like rental payments to credit-rating agencies. Visit the Credit Builders Alliance website to find the names of non-profit organizations in your community that might do this.
Another way to build credit, whether you’re banked or unbanked, is through a practice called lending circles. Based on centuries-old practices, a lending circle is essentially a group of people lending money to each other at no interest. Each member of a circle chips in each month to provide a pool of money that is loaned to each member on a rotating basis. Lending Circles are practiced widely throughout the world and go by a variety of names such as tanda, ayuuto, or hagbad.
Formal lending circles track members’ payment history and report it to national credit bureaus. This way, formal lending circles help members start or improve credit histories, which is essential to getting access to the mainstream financial system and affordable sources of credit. Learn more about lending circles through the Mission Asset Fund, a pioneer in formal lending circles. MAF works with partners across the country, including CLUES (Communidades Latinas Unidas en Servicio).
Remember — your most important goal is to build wealth. Finding ways to minimize use of alternative financial services and avoid debt are the first steps toward creating a better financial future for you and your family.
Consumer Financial Protection Bureau. (n.d.). Ask CFPB: Payday loans
Federal Deposit Insurance Corporation. (2016, October 21). 2015 FDIC National Survey of Unbanked and Underbanked Households
Federal Reserve Bank of Minneapolis. (2000, October 1). A helping hand, or new age loan sharking?
Being Unbanked — What Is it? What Are the Implications? — Increase your awareness of the unbanked population and the issues that surround their situation.
All About Prize-Linked Savings Accounts — Get the scoop on the prize-linked savings accounts that are now available through participating Minnesota credit unions.