Why This Type of Loan Is the Biggest Scam

Payday loans are designed to create a vicious circle of ever-deepening debt.

Recently, there was an interesting exchange on Twitter. It began with Twitter superstar Nathalie Jacoby tweeting this question to her followers: "What's 100% a total scam, but we still accept it in society?"

As you might imagine, people had all kinds of clever responses. One of those responses came from money and career expert Tori Dunlap, founder of Her First $100K. Dunlap answered simply, "400% interest on payday loans."

Dunlap was right. Payday loans are officially the biggest loan scam perpetrated on unsuspecting borrowers. Here, we break down payday loans and offer ideas to help you avoid predatory lenders.

They make it easy

Let's say you need money fast. It's the dead of winter, and your furnace no longer blows warm air. You consider applying for a traditional personal loan from your credit union, but you're in a hurry. Besides, you're afraid that your low credit score will make loan approval impossible. And so you stop into your local payday lending store. They'll give money to anyone.

The person behind the partition is nice enough, and they make the entire process easy for you. All they ask to see is your identification and most recent pay stub. They give you two options:

• Write a post-dated check for the full loan amount, including fees, or
• Sign an authorization permitting them to debit the money owed from your checking account

"But don't worry," they tell you. "We won't cash the check or debit your account until your next payday."

What's really going on

They tell you that your interest rate is 15%, which doesn't seem so bad. In fact, it's lower than the average credit card rate these days. What you need to look for is the annual percentage rate (APR), breaking down the true cost of a loan.

Say you borrow $1,000, and the payday lender charges you a $15 fee for every $100. That's a simple interest rate of 15%. But here's where things get dicey. You're expected to repay the loan in 14 days when your next paycheck arrives. Due to this very short loan term, the actual amount you're paying for the loan (the APR) hovers around 400%.

Designed to fail

It is no surprise to payday lenders that people who come to them for money are desperate. After all, they would visit their local bank if they had high paychecks and great credit scores.

Sure, predatory lending rates bring in the big bucks, but more is made when a borrower is forced to roll one loan over into another. Once that happens, the lender has the interest and fees charged on the first loan, followed by the interest and fees they charge on the new loan.

Better yet? The borrower must now pay interest on the interest associated with the first loan.

According to the Consumer Finance Protection Bureau (CFPB), over 80% of payday loans are rolled into a new loan within 14 days. And the deeper a consumer gets into the payday loan cycle, the harder it is to get out. CFPB reports that half of all payday loans result in the borrower rolling the loan over at least 10 times.

Alternatives

We've all run into a financial wall we didn't know how to climb over. There's no shame in that. But if you need money and you need it fast, here are a few other options to consider.

Friends and family

If you don't need to borrow much and are confident you can pay it off quickly, let a good friend or close family member know what you're going through. If they offer to lend you the cash, write an IOU clearly outlining when the loan will be repaid in full.

Credit card

If you have a credit card, check the interest rate. Chances are, it's a small fraction of the rate you would end up paying a payday lender. Again, make a plan to pay it off as quickly as possible. There's no reason to take money out of your bank account to make a credit card company richer.

Credit union

If you're a member of a credit union, that means that you're also a part owner. Because of that, credit unions have more flexibility when it comes to lending. Go in and explain your situation and ask about a short-term loan. Your history with the credit union may give you a leg up.

There is nothing redeemable about payday lenders, which makes it no surprise that they're illegal in some states.

If things are going relatively well today, the best thing you can do for yourself is to start building an emergency savings account. Consider this: If you put $100 a month into the account, you'll have enough to cover small emergencies before the end of the year.