I consider payday loans one of the worst forms of debt. That being said, in states where these services are still legal, they provide a way for struggling individuals to afford necessities like food and housing until their next paycheck, for a fee. Unfortunately, many borrowers don’t simply use their paycheck to pay back the loan and move on when it is due. One loan is often rolled into the next, for another fee.
A typical fee for a payday loan is $17 per $100 borrowed. That fee is due when the loan is repaid, usually within one or two weeks. While this cost of the loan could be considered a 17% fee, an annual rate is used to compare payday loans with other loans. The annual interest rate for a consumer loan from a bank may be 10%, but the payday loan works out to an annual rate of almost 450%, assuming the loan carries a term of two weeks.
The operative phrase is “a term of two weeks.” How is it rational to compare these two products using an annual interest rate? Only if the loan is extended and renewed repeatedly does it become a significant financial burden worthy of the interest rate stigma of 450%.
I am not defending payday loan companies. These lenders prey on individuals and families in desperate financial situations, often with nowhere else to turn. There is a strong possibility of borrowers falling into a spiral of increasing debt with back-breaking fees, and this is why these products are becoming illegal in more states. Arizona is the latest state, banning predatory loans with interest rates higher than 36%.
I do, however, believe the numbers used in the argument against payday loans are often illusory. Should loans due within two weeks annualize their fees into interest rates to face comparison with long-term loans?
Updated March 7, 2012 and originally published July 14, 2010.