Strategic Default Monitor – How To Strategically Default

Monday, July 18, 2016

Weekly Alert: The Terror of Payday Loans

Introduction

What are payday loans? Simply put, a payday loan is a short-term loan (originally meant to be lend out for a few days or a couple of weeks) at a relatively high interest rate. However, they're often times targeted to low-waged individuals and are designed to tide them into a situation where they find themselves constantly unable to pay off the resulting interest amount.


Objective Understanding

Like any lending, if payday loans are used responsibly by those who understand what they're doing, they might actually be reasonable for certain situations. Logically, payday loan companies charge high interest because their margins are much lower than bank and credit card loans due to the high default rate. As such, these companies and type of loan wouldn't exist without those high interest payments.

However by the very nature of the situation of the people they're targeted at, they tend to seduce people into a perpetual state of debt. It's not uncommon for people to take out one payday loan to pay off a different one, or to have multiple loans running simultaneously. Because of the high interest rates and penalties for default, comparatively small loans can quickly spiral into completely ridiculous amounts.

The Cycle

Lets pretend your only car that is used for your daily work commute broke down and you are in a situation where payday loans were probably the only credit source available (this is a critical point because most payday borrowers don't have access to credit cards or bank loans). Therefore, if you had no savings nor friends and family to rely on, there's no other way to pay the amount needed to fix the car. 

For this example, we will say you take out a payday loan for $200 in order to get your car fixed up and were charged $60 for up to 15 days. At this point, your plan might be to repay the money when you receive your next paycheck in two weeks. However, fifteen days later, you had to pay other bills/daily necessities you forgotten to account for and still don't have the $260 needed to pay off the amount you borrowed plus the $60 fee. So you decide to roll your payday loan over for another two weeks for an additional $60 fee. This continued for the next six months, at the end,you now owe $720 in fees and still have to pay back the original $200.

In this rather modest situation where you were offered a flat fee instead of the more common absurd high-interest rate, you still easily end up owing more than you can reasonably pay back. This shows that repetitive extension of a payday loan may force you into a cycle of debt that cannot be broken. So if your only options were either the payday loan or leaving the car unfixed and potentially lose your job, it turns into a "damned if you do, damned if you don't" situation.


Additional Resource

Here is a link to a video by John Oliver providing great explanations about payday loans and predatory lending in general.

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