Many people take out an emergency loan to meet daily expenses without overdrawing on their checking account. But most people aren’t able to pay back their loan in full by the end of the term and make the next week’s expenses; instead, they take out another payday loan, and another, and another. And even when trapped in the payday loan cycle, many borrowers are hit by what they wanted to avoid: Overdraft fees.
How a Payday Loan Can Make You Overdraw
According to a recent study by the Pew Research Center, 27 percent of payday loan borrowers say that the loan directly caused them to overdraw on their checking accounts. How can this be the case? It has to do with how payday loans are set up.
Emergency loans often don’t require a credit check; they just need proof of employment and access to your checking account. This verifies that you have enough income to pay off the loan, and gives the lender a method to do so. Typically, the lender deposits the loan straight into your checking account. It’s convenient for you – but by allowing the lender to do so, you often authorize them to take the money back the same way. They automatically deduct the money you owe from your checking account.
If you don’t have enough funds in your checking account to cover the balance of your payday loan, not only will you incur a bounced-check fee from the payday lender, but you’ll also get hit with – you guessed it – an overdraft fee. This back-door collection method is part of the reason that over one in four borrowers say a payday loan caused them to overdraw.
No Way Out of the Cycle
Another insidious feature of payday loans is that they don’t help to build your credit score. Unless you miss a payment or default, lenders typically don’t report to credit bureaus. By and large, payday loans can’t help you build credit; they can only hurt.
Moreover, once the bill comes due, most payday borrowers find themselves in the exact same situation they were before: Short of cash and unable to pay their bills. 86 percent of borrowers don’t have enough room in their budgets to pay off the average payday loan, so they turn to tax refund loans, pawnshops and friends and family or take out yet another loan.
Alternatives to Overdrafts and Payday Loans
If you’re worried about overdrafts, consider a checking account with no overdraft fees such as the Capital One 360. If you have sufficient credit, you can also qualify for an overdraft line of credit, which essentially loans you money at a relatively low 11.25 percent interest rate (that’s compared to over 300 percent APR with payday loans). Some credit unions also offer no-overdraft-fee checking accounts; others offer second chance checking if you’ve been blacklisted on ChexSystems.
A checking account won’t help you build credit, though. For that, consider a small-dollar credit union loan. These loans are designed as an alternative to expensive payday loans, and have a maximum interest rate of 28 percent. Moreover they’ll report to credit bureaus and help establish a credit history. Also, if you’re in the military, you might be afforded special protections and have access to better loans.
Payday loans can trap you in a vicious cycle of borrowing, while incurring the very fees you’re looking to avoid. Be very cautious about taking them out, and consider the alternatives before you do.
Anisha Sekar is the chief consumer advocate at NerdWallet.com, a personal finance website whose most recent initiative provides free financial advice on topics ranging from marriage to estate planning.