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Payday Loans: Inside The Money Trap

Consumer advocates agree that payday loans and new deposit-advance loans trap consumers by charging outrageous interest rates and soaring fees. However, we still are waiting to see whether regulators will finalize rules that curb the abusive practices of banks and traditional payday lenders.

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Stretching a paycheck to cover a month of bills or a financial emergency is a mathematical balancing act that falls flat for some budgets. So it might sound tempting to head to a store or go online and be approved without a credit check for a short-term loan for a quick $350. You should fight that temptation.

Each year 12 million Americans take out a payday loan, according to Pew Charitable Trusts’ 2012 Payday Lending in America study. The demand for payday loans has grown to the point where, in the past 2 years, at least five major banks—Bank of Oklahoma, Fifth Third Bank, Guaranty Bank, Regions Financial and U.S. Bancorp—started to offer what are called deposit-advance loans, which are similar to payday loans. (Wells Fargo has offered its Direct Deposit Advance service since 1994.)

Advocates say payday loans are a safety net for consumers in the case of a financial shortfall. However, according to an April 2013 report by Consumer Financial Protection Bureau (CFPB), payday lenders typically trap consumers in a web of debt and fees by lending money to borrowers who can’t afford to pay it back.

“These loans are designed to take advantage of consumers who have an immediate need for credit,” says Tom Feltner, who is the director of financial services at Consumer Federation of America (CFA), which is a consumer-advocacy organization.

Since 2009, we’ve seen an increase in regulation and protection on many consumer financial products, including credit cards and mortgages. However, little regulation of payday loans has happened. Current attempts to regulate the market include a bill in the U.S. Senate that would crack down on online payday lending and an April 2013 proposal by Federal Deposit Insurance Corp. (FDIC) and Office of the Comptroller of the Currency (OCC) to regulate deposit-advance loans. At press time, the bill was pending, FDIC and OCC still were gathering public comments and it was unclear when, or whether, new rules would be in place. CFPB wants to issue rules on payday loans in 2013, but as of press time it was unclear what those rules would contain and when the agency would issue the rules.

Feltner’s concern is that by doing nothing, regulators essentially have blessed payday loans and their close kin—the deposit-advance loan. We agree. In fact, we can’t say it enough: You should avoid payday loans at all costs.

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SETTING THE TRAP. Payday loans come with median fees of $15 for every $100 that’s borrowed and a median interest rate of 322 percent, according to CFPB’s 2013 report. Only 14 percent of borrowers can afford to pay off a payday loan within the median loan term of 14 days, according to Pew.

To get a payday loan, a borrower typically hands over a postdated check to a lender or agrees to allow the lender to withdraw money automatically from the borrower’s checking account. If not enough money exists to cover the loan and its corresponding fees at the time that the loan comes due, the borrower has to take out another loan, which has new fees, to avoid an overdraft in his/her account, which results in fees that are charged by his/her bank. Payday loans don’t show up on a credit report by the three major credit bureaus, but experts tell us that if a delinquent payday loan is turned over to a collections agency, then that activity will end up on your credit report and likely will harm your credit score.

The cost of a loan quickly can double as fees spiral upward, CFPB says. The average payday borrower takes out eight such loans per year, pays a total of $520 in interest and ends up indebted for 5 months, Pew says.

Eighteen states and District of Columbia banned or all but banned payday lending in storefronts, according to CFA. (See “State by State: Payday Loan Regulations.”)

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