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How Do Payday Loans Work?

by:
Doris Asiedu

According to recent surveys, most Canadians are living paycheque to paycheque. If you're in such a situation, covering expenses can be an uphill battle, and unexpected bills can throw you into a full blown financial crisis. Payday loans may seem to offer some relief – especially if you have an urgent need for cash before your next paycheque. You can just simply walk into one of the many payday loan centres across town and walk out with cash. This might seem like a quick and easy solution, but you could end up in worse financial situation. Is a payday loan the right way out? Let’s evaluate:

What Are Payday Loans?

Also referred to as ‘Cash-Advance-Loans,' payday loans are short-term loans payable on your payday (typically at the end of the month). However, the duration may be extended using ‘rollovers,’ which we’ll explain later.

If you're in a desperate situation, these loans may seem very attractive at first glance, but there’s a catch: high interest and the of risk getting into a never-ending cycle of debt.

What Makes Payday Loans Attractive?

Immediate Cash

Let’s face it, many people are dealing with serious cashflow issues. Our everyday expenses take up most, if not all, of our income – while the cost of living just seems to keep rising – and for most of us our budgets simply can’t take another hit, such as an unexpected car repair bill, dental emergency, or leaky roof. When these things happen, many of us feel like we have no choice but to surrender to a payday loan, but it doesn’t have to be that way, and we’ll explain why a little further on.

No Credit History Required

When it comes to traditional bank loans, you're required to prove your creditworthiness to determine the amount and rate you qualify for, and if your credit isn’t exactly stellar, you may not qualify for the loan at all. However, you don’t need good credit to access a payday loan. You only need a bank account, government-issued ID to prove you’re at least 18, and proof of income (e.g. pay slips).

Offers Renewal/Rollover

If you’re struggling financially, you can renew the loan before it's due. This will, however, require you to pay a fee equivalent to the interest you owe, after which you have an additional two weeks to repay the loan with another corresponding interest payment. Alternatively, you can take a new loan to cover the first one, which also extends your repayment date.

Precautions Before Taking Payday Loans

Payday loans might seem convenient when you’re in a tight financial situation. However, what are their downsides, and are they worth it?

High-Interest Charge

The average person doesn’t understand the actual interest on payday loans. Most people see $18 for every $100 borrowed and they think the interest rate is 18 percent, which seems reasonable compared to other credit products and interest rates. However, what most people don’t realize is that the interest rate on their credit cards and other loans is calculated on an annual basis, whereas with payday loans it’s bi-weekly, so $18 for every $100 borrowed actually works out to an interest rate of about 468 percent – how do you like them apples?

Limited Amounts of Cash

You can only access a limited amount of cash, which may not necessarily meet your needs. This amount usually ranges from $300 to $1,000, depending on how much risk you pose to the lender.

Short Repayment Period

Typically, you are supposed to repay the payday loan by your next paycheque. Although you can extend the repayment date, there are limits on the number of times you can extend it by. This is a sharp contrast to traditional loans, which may have long negotiable repayment periods.

You Can't Pay in Installments

Traditional bank loans offer you the luxury of paying the loan in installments, which both you and the bank agree upon. This offers some flexibility for your budget, which can also lessen the debt burden. A payday loan, on the other hand, requires that you repay the whole sum, interest and principal inclusive, by the next pay period, which can be a tall order for someone living paycheque to paycheque.  

The Payday Loan Cycle

One of the biggest risks payday loans pose to anyone who uses them is that you can end up in an endless payday loan cycle, where you take out payday loan after payday loan, trying to catch up and pay off the previous loans, but you can’t because your debt just keeps growing. The simple truth is most people who use payday loans have limited income – that’s why they need a payday loan in the first place. But if you have limited income, it’s nearly impossible to pay the payday loan back given the interest and the repayment period. It's a catch-22. 

At best, payday loans are packaged as short-term fixes for emergency needs, such as home repairs and medical bills. However, studies show that most people use these loans to meet basic needs or to cover credit card bills. This explains why payday loans are synonymous with endless cycles of debt.

What Are The Alternatives To Payday Loans?

There are more affordable and sustainable alternatives to payday loans. The best thing anyone can do when facing a situation where they feel they have no choice but to resort to a payday loan is speak to your creditors, as well as a certified not-for-profit credit counselling professional who will give you free advice.

Sometimes it’s possible to work with creditors and ask about alternative options, given a particular financial difficulty you’re facing. But this is where working with a certified credit counsellor can really help, because they can negotiate with your creditors for you. They will also do a full financial assessment where they’ll look at all your expenses and monthly payments, then give you all the options available to you. They’ll go over the pros and cons of each, and then you can decide what action to take – all for free.

Our goal at Credit Canada is so that you never have to rely on a payday loan again, whether that’s helping you set up an emergency fund, getting you on a debt consolidation program and helping you manage your debt, or helping you rebuild your credit. Every situation is unique, so it’s important to look at yours in particular to pick the right option.

At Credit Canada, we offer free debt and credit counselling, as well as free money management workshops and budgeting seminars. We’ve helped over two million people and we can help you evaluate all of your options and select the best plan of action that will work for you, your income, your monthly bills and your goals. Contact us today to learn more.

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Topics: Money Management

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