How Online Payday Loans Can Get You in Trouble

Kim Higdon separated from her husband of more than 25 years, taking nothing but her clothing and daughter. She managed to scrape by until she broke a tooth. The dental bill took all the money she had, and she had to borrow $500 from an online payday-loan provider to cover rent. That loan was expensive: She paid 798% interest for the six days it took for her paycheck to arrive so she could pay off her loan.

As absurd as it sounds, Higdon got off lucky compared to many other borrowers of online payday loans. At least she was able to pay off her loan, albeit at nearly nine times the amount she borrowed. For many others, the cycle can quickly morph into a mess.

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Using a more conservative scenario, Jeffrey Woolf, a certified financial planner, explains how this happens: Say someone takes a $500 advance with a 20% interest rate and owes $600 when the loan comes due. This may force the borrower to take another loan out to cover the principal and interest owed, potentially leaving the borrower even shorter than he or she was the first time. The borrower then takes out $600, which costs $120 in interest by the end of that second loan. If this cycle repeats once a month, the original $500 loan ends up accumulating interest at an annual percentage rate of more than 791%.

Barring a financial windfall to the borrower, it may be very difficult to ever get out of this cycle when a $500 advance
turns into a $500 principal loan with $3,950 in interest over the course of 12 months, Woolf says. And Higdon paid more than that for a loan of only six days.

"Only take a payday loan if you can pay it off immediately," says Higdon, an executive assistant in Louisville. "And I would not recommend it as an ongoing source of income -- that interest adds up quickly and could easily become a vicious cycle of borrowing and paying back, only to have to borrow again in a few days."

Making a Bad Situation Worse

It may feel like desperate times call for desperate measures, but -- when it comes to online payday loans -- taking them may make a bad situation worse.

"Payday loans may serve a short-term need, but they also can create a greater long-term problem," says Frank Dombroski, founder of FlexWage, which recently launched an employer-sponsored alternative to payday loans that allows employees to access earned wages that haven't yet been paid.

The problems don't stop at the sky-high interest rates, either.

The Federal Trade Commission this month filed a complaint against mypaydayangel.com and juniperloans.com. The sites asked for customers' personal and financial information, such as their social-security, driver-license and bank-account numbers. Near the end of the application form, the websites offered unrelated "Direct Benefits" and "Voice Net" programs for food, travel and merchandise discounts, long-distance calling or Internet access.

Many consumers who clicked to "submit" a payday loan application were unwittingly enrolled into the programs, which initially charged their bank accounts up to $59.90 per month and later charged up to $99.90 per year. Many customers didn't notice the offers, and some of those who declined the offers were charged for the programs anyway, according to the FTC.

"Payday loans and various types of perceived 'predatory' consumer finance offers are drawing the attention of regulators," says Richard Newman, an attorney with Hinch Newman, specializing in Internet law. "Offers for payday loans are most often run by lead generators who seek to sell those leads to numerous clients."

Borrower Beware

Predators lurk at time when many are vulnerable. In this economy, many consumers feel like they need a magic wand to pay the bills. And, when you're in a tight spot, online payday loans can certainly be tempting. After all, the money is often transferred to your account within a few hours, you don't have worry about faxing or printing any paperwork and you can generally avoid credit and income checks.

Most online payday-loan lenders even provide support 24/7, says Andrew Schrage, an editor with MoneyCrashers.com. "They are one of fastest and easiest loans to get," he says. In many cases, all you need is a prior paystub proving payment from an employer, he says.

But what's easy isn't always what's good for you. "These loans [are] targeted to, and used by, those individuals who can least afford the costs," says Eleanor Blaney, consumer advocate for the Certified Financial Planning Board. "The interest rates charged are very high, and also not very visible. One of my biggest criticisms of the online services is that nowhere are the interest rates or costs given, nor is there any advice to potential users of these loans [about] what the costs can accumulate to, if these loans are not paid off in very short order."

Quite simply, they are one of the most expensive forms of credit, says Eli Lehrer, vice president of the Heartland Institute, a think tank. "Calculated as an APR, their costs are higher than any credit card, consumer loan or bank loan."

True, some online payday-loan providers have lower rates than their brick-and-mortar brethren. It can also be easier to compare online services than storefront providers. But Lehrer finds little else good to say.

Other Options

If you're cash strapped, your credit cards are maxxed out and your friends and family can't help you, you still might have some other options aside from a payday loan. What else can you do?

• Try a credit union. Credit unions often maintain payday-lending-like operations that are much less expensive than payday loans, Lehrer says.

• Check out peer-lending services, such as Prosper or Lending Club, which allow you to post information about your debt situation to your fellow peers, who can then decide to offer you a loan at a more reasonable rate, Schrage suggests.

• Talk to your employer. If you feel you have no other option but to borrow against a later paycheck, speak to your employer. In some cases, says Blaney, an employer might be willing to offer short-term assistance with considerably lower costs. The employer, too, might be able to assist with setting up bank accounts into which your income can be directly deposited.

• Negotiate with your providers. "Many types of 'emergency' costs that lead people to take out payday loans, such as medical bills, can also be paid over time through an agreement with the provider," Lehrer says.

Before You Sign Up

If, after careful consideration, you still decide to pursue a payday loan, here are some suggestions from the experts:

• Compare the likely actual cost of each option, Lehrer advises. Be aware that different companies arrange fees in different ways. The bottom line isn't the upfront fee or the interest rate, but rather the total amount of money you will have to pay out of pocket. If the only alternative is a bank overdraft fee, for example, a payday loan can sometimes be a good deal financially, he says.

• Check with at least two payday loan companies before signing up.

• Verify the domain of any website offering these services with a service such as VeriSign or McAfee, Schrage says.

• Be leery of using any service that sends you unsolicited emails.

• Figure out a realistic payback strategy. If it's going to take several pay cycles to pay the loan off, make your cost comparisons based on the entire life of the loan. The cheapest loan for the first week may not be the best over the life of the loan, points out Frank Dombroski, founder of FlexWage, which recently launched an employer-sponsored alternative to payday loans that allows employees to access earned wages that haven't yet been paid.