Finance 101: Basics of Cash Advance and Payday Loans

It’s no secret that the American banking industry has undergone major challenges and transformations over the past two years. Institutions have closed ranks and have reduced the amount of money available to borrowers. This includes everything from declining to offer certain types of consumer loans to reducing the credit limits of millions of borrowers. According to a recent Wall Street Journal article, the total lending funds available to consumers fell to $433 billion in 2010, “down 51% from $887 billion in 2007”. Borrowers that make up the low end of the credit community have virtually been left with no recourse for fulfilling their short term lending needs. In stepped cash advance and payday loan establishments.

According to Investopia, a cash advance is, “a loan taken out against a line of credit or credit card, typically imposing higher-than-normal interest charges. Often the interest charged on these loans is a fixed number of percentage points above the prime rate. Additionally, there is seldom a grace period in which no interest is charged. These two factors make cash advances more expensive than many other types of debt financing.” A cash advance is slightly different from its cousin, the payday loan, in that the payday loan is often totally unsecured and does not require the borrower to take a loan from the available balance of a credit card.

Cash advances and payday loans are usually for very short periods, often up to two weeks, and are known for charging very high interest rates. Loan fees and rates have been high enough to be termed predatory in some states. This led to them being completely banned in a few states, highly regulated in others, or emergency cashhaving the loan interest rates capped at the same rates allowed for credit cards in others. The industry often combats this perception by stating that its total fees are in line with fees charged by other institutions. The Wikipedia entry for payday loan has a great comparison of rates:

  • $100 two week payday advance with $15 fee = 391% APR;
  • $100 bounced check with $48 NSF/merchant fees = 1,251% APR;
  • $100 credit card balance with $26 late fee = 678% APR;
  • $100 utility bill with $50 late/reconnect fees = 1,304% APR.

A more accurate comparison of the rates would be the effective annual rate (EAR), which calculates the compounded interest, and not the simple interest. Thus, a $15 fee on two-week $100 loan might not seem like much but works out to 390% APR and a 3,685% EAR. Ouch!  It should be noted that these loans are never loaned on an annual basis, but on a maximum of a two week term.  Industry lenders say that they must charge these levels of interest because of the high default rates that they suffer.  Indeed, these types of loans are unsecured and a borrower’s only proof of their ability to repay the loan is a recent pay stub or bank statement.  Some internet payday operations have been known to not verify proof of income documentation, so I am sure that defaults are a major problem within the industry.

Since cash advance and pay day loans are often for small amounts (usually a few hundred dollars) a well prepared person can avoid their use by having an emergency fund of even $1,000.  Those without such funds finding themselves in an emergency situation where they need cash quickly should exhaust all other avenues for a small short-term loan including:
  • Obtaining a payroll advance directly from an employer
  • Borrowing from a close family member or friend
  • Selling an item to a broker
  • Selling unneeded items on Craigslist

While payday and cash advance loan companies do charge high rates, a well informed consumer can take advantage of these services in an emergency situation.  You must be realistic about how much you can truly afford to borrow and your ability to repay the loan in full within the time allotted.  Also, borrowers should avoid the cycle of borrowing against a future paycheck then falling short of covering expenses once the paycheck arrives because of the cash advance debt that must be repaid.  Know that cash advance loans are not a long term solution to managing budgetary shortfalls or debt repayment.  Again, these are short-term solutions that should be used in emergency situations only, for the most minimal amount of cash needed.

Anyone thinking of getting a payday or cash advance loan should read all of the terms of the loan carefully.  The Community Financial Services Association of America, the industry’s trade group, tells its member companies to “display fees in large type on posters in all store locations and offer customers the option of an Extended Payment Plan, at no additional charge, if they cannot repay their loan when due.”  Customers should carefully evaluate companies through a cash advance comparison service and never use this service as a long term debt management solution. Remember, even the smallest emergency fund can come in handy in an emergency.

Readers, have you ever used a payday or cash advance loan company?  What was your experience?

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13 thoughts on “Finance 101: Basics of Cash Advance and Payday Loans

  • While we were researching these types of places, it seems my fiance applied for one. So there’s $350 in our checking account that I know is going to be taken out with enormous interest, putting us in even more debt than before. I’m pretty angry.

    • Let’s see that $350 is probably going to cost you around $50 if paid back within two weeks. Did he take one out because he could or did he actually need the $350? Remember, these should be used in case of emergency if you don’t have an emergency fund.

  • Payday loans and the like are indicative of being out of financial control. When you have financial difficulties, you make bad decisions. I never used payday loan services, but I understand their purpose.

  • I’ve been fortunate enough to never need these types of loans. While I deplore the high interest rates that are charged, I understand the high risk of default by the borrower. Almost by definition, most people would would resort to payday loans are a credit risk. Hence the predatory rates.

  • Hi Sandy, I haven’t used a payday loan, although I pass these places almost every day. I could see using one in an extreme emergency, but generally I agree with krantcents that they are a sign of poor financial planning. I’m not surprised to see them go up in popularity between the bad economy and the bankruptcy of banks like WaMu who used to loan to everybody, legal resident or not. While I understand payday borrowers default a lot, I still believe the effective interest rate is excessive and predatory. I agree with you that selling your stuff to build up an emergency fund is the smart thing to do.

  • Great post! I was unfortunate enough to get caught in a payday loan cycle for a brief time in college. My budget was super-tight, yet I advanced $50 on a paycheck to go on a trip one week — at 20% interest! The following week I needed to advance again just to cover normal bills. After a month of this, I finally broke down and asked my mom for money. Never again will I do a payday loan (or a cash advance)!

    • That’s the cycle that I was talking about. It’s hard to get out of it when you’re in it. That’s why I would only use this option in an emergency situation where I had absolutely no money and needed it today.

  • Basically we were researching most of these places, it seems like my fiance applied for one. So there’s $350 within our bank checking account which i know will likely be obtained with enormous interest, putting us in much more debt than before. I’m pretty angry.

    • That’s pretty tough. I would pay it back as soon as possible and see why your fiance needed to use this service.

  • Your suggestions on borrowing from one’s employer, family members or friends is one of the safest ways. These cash advance and payday loans are marketed to be really attractive to those who are in need but are risky. As much as possible, in order to avoid financial trouble, manage financial resources well.

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