10 September 2008

Ask the Loan Shark, part one

I work in the payday loan business, and I often am asked about the mechanics of payday and short-term loans. Here is part one in a series of informational entries on these types of loans:

Q: When I take out a payday loan, what can I expect to pay back?

A: Since these loans are designed to be strictly and specifically short-term loans, the interest rate is staggeringly high. Typically, a payday loan's interest rate is around 15-20%, meaning that for every one hundred dollars you borrow, you can expect to pay back anywhere from $15 to $20. For fourteen to thirty days, that may not seem like a lot, but when you look at the APY (annual percentage yield), that number can be anywhere from 400-500%. You read that right. Upwards of five hundred percent interest. As a point of comparison, most credit cards carry an APY of about 20%.

Some payday loan companies offer refinance options per loan. When you refinance, you pay down a small percentage of the amount you borrowed (the principal), plus your finance charge (the interest). For instance, in Missouri you are required to pay down 5% of the principal along with the finance charge, and this allows you to extend the loan to your next pay date. Many places allow you to refinance two or three times before you have to pay off the loan. While this doesn't sound like a bad option, it can end up costing you much more than when you simply pay off the loan in full on the maturity date.

For example, let's say you borrow $100 at 18% interest in Missouri, making your full payoff on the maturity date $118. Not bad, but let's say you don't have the full $118 on your due date. You opt to refinance at this time, paying $5 plus the $18 finance charge - $23 total. This reduces your principal to $95, but remember, there is still interest between now and your next maturity date. Add this interest, and your new payoff amount is $112.10 ($95 plus 18% interest, which would be $17.10). Let's say your next maturity date comes around, and you still don't have the full amount of $112.10, so you opt to use another refinance. This time, you pay $5 towards your principal plus $17.10 - $22.10 total. Your new payoff is now $106.20 ($90 plus 18% interest, which is $16.20). Now, your next maturity date comes around, and you're still strapped for that $106.20. You decide to use your last refinance, paying out another $5 plus $16.20, so $21.20 total. Your final payoff will be $100.30.

Now this may look like a lot of numbers and symbols, but let's break it down in the most simple terms possible. You borrow $100. You refinance that $100 three times. By doing so, you've paid back a total of $166.30! It's a far cry from that $118 you could have paid back in total on your first maturity date, isn't it? When you refinance, most payday loan companies only require that you pay down that tiny fraction of your principal balance.

The two simple solutions are this: One, pay off your loan in full on the first maturity date. Don't refinance at all. The other solution: If you must refinance, put as much extra on the principal as possible. Don't settle for the bare minimum. Even if you can add an extra five to ten dollars, it will make a difference. The same goes for any kind of high-interest loan, including credit cards. If you simply pay the minimum, you won't create any real dent in your debt. Always pay extra when you can't pay it off.

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