Payday loans 101

Written by Preet Banerjee

Thursday, January 18th, 2018

Payday loans can charge 400% annual interest (often more!) to people who want to get a short-term, small loan.

Here's a typical example: Say you wanted cash fast and had nowhere to turn. You might walk into a payday loan operator and arrange for a small loan of a few hundred dollars until you receive your next paycheque. Normally you'll get a cost quote such as "$21 per $100 borrowed". Your gut instinct might say that works out to a 21% interest rate, but that would only be true if you had a year to pay back the $100. Payday loans often need to be paid back by your next payday, hence the name. If you borrow that money for just 14 days, the annual percentage rate being charged in this case is 547.50%. That's not a typo.

You might wonder why payday loans would even be allowed in Canada, but there are those who argue that these types of products fill a very specific niche. They're useful for high-risk borrowers who require small amounts of money in emergencies and have few options when it comes to sourcing funds. And while the effective interest rates are through the roof, operating costs and the fact that many people default on these loans mean that payday loan operators don't make as much money as you would think. They make a killing on the people who do pay back the loans, but take a bath on the ones who skip on paying them back.

The real problem is that even if you accept that the use of a payday loan can be justified in very, very dire situations (where the alternative to obtaining funds would be even more harmful in some way), they often lead to a vicious cycle that can wreak havoc on your finances for a very long time.

There are countless stories of people who rotate between different payday loan operators because they've become stuck in this vicious circle. They get one loan, but after paying the fee, they immediately require another loan. That puts them even deeper in the hole. They get a new payday loan for a slightly larger amount. They may not even have the money required anymore to pay it back after the fees, so they arrange for a new payday loan from another provider to pay off the existing payday loan. And on and on it goes.

People don't tend to turn to payday loans until they've already gotten themselves into a financial mess to begin with. They might have maxed out their credit cards, lines of credit, and any other more traditional sources of borrowed funds.

This is a case where an ounce of prevention is worth a pound of cure. Of course it's clear that you would want to avoid a payday loan. So the answer is to make sure you never get into a situation where it's your only option. That means keeping on top of your debts, running a surplus, and building up an emergency fund. If you do that, you'll never be in a situation where a payday loan makes sense.

To learn about the real nitty gritty of these loans, you can read this article in The Globe and Mail, which includes a video explaining the math behind the stratospheric interest rates. 

 

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