Payday Loans: Free Lunch or Necessary Evil?

As the old adage goes, there is no such thing as a free lunch. The temptation, however, comes up quite often (especially among people living from paycheck to paycheck) to utilize emergency short-term loans, or payday loans, as such.

Wouldn’t it be great to have the full amount of a paycheck now rather than later? Could this be the one exception to “there is no such thing as a free lunch?” Unfortunately, no.

It’s not that easy, and there are many hidden dangers to emergency short-term loans that are not obvious at first.

How Short-Term Loans Work

Emergency short-term loans generally work in this way: let us assume that a man has bills due, but his paycheck will not arrive for another week. What can he do to make up the difference in the meantime? He can go to a payday loan company and ask for a check for, say, $300. He will sign the terms of the agreement and leave a check for an amount greater than $300 – for this example, perhaps $350 – which will be post-dated a week.

This check will then be cashed by the payday loan company in a week, so it is important that this gentleman gets the necessary funds into the bank account before the payday loan is due, or he will have his bank account overdrawn.

The Snowball Effect

What is the danger of such a loan? If the means of paying back the loan are not responsibly planned, then the danger lies in the potential that the check will bounce. If this occurs, then the loan begins to snowball in ways much more dangerous than the snowballing of credit card debt.

It is not at all uncommon to find people who use payday loans from one company to pay for payday loans that are owed to another company, all the while not building up the resources in their bank accounts to pay back the initial payday loan.

How Emergency Short-Term Loans are Used

What is the annual interest rate of a two-week payday loan for the amount of $200 that is taken out with a $40 charge? Surely a 20% interest rate (40 ÷ $200) is not terrible. That calculation is a fallacious one, however.

Since the interest rate, in this calculation, is for two weeks, it is necessary to multiply that figure by the amount of pay periods in a year to find the Annual Percentage Rate (APR). This leads to a 520% APR.

That amount is not a misprint; 520% APR is the interest that is paid on this payday loan, and that is not even calculating compounding interest rates, which would put the APR into the thousands.

What This Means

If possible, given the astronomical APR of payday loans and the risk of the snowball effect, the wise consumer will stay away from them and will try to find friends who can help out in emergencies.

If, however, all resources are exhausted and there are no other ways to find funds to pay for emergencies, then payday loans may be a necessary evil. It is important, though, to remember this: necessary evil though they may be, there is no such thing as a free lunch.