How to avoid the payday loan trap

This post comes from Linda Doell at partner site Money Talks News.

Payday loans, no matter how reasonable they might look on the surface, are nothing less than a financial kick in the stomach, often delivered to those least able to afford it.

A new report by the Pew Charitable Trusts (.pdf file) says almost 12 million Americans take out payday loans every year. And as you might imagine, the borrowers are frequently those least able to afford it. According to Pew, the typical borrower is white, female, 25 to 44 years old, without a college degree, and making less than $40,000 a year.

The report shows that a majority of those surveyed -- 58% -- had trouble meeting monthly expenses at least half the time and turned to payday loans as a financial option to handle the shortfall.

How payday loans work

Payday loans are small, short-term loans backed by your paycheck. You apply for a loan, listing your next two or three pay dates on the application. After getting approved, you write a postdated check for the loan amount plus interest and fees. On your next payday, the lender collects the balance, unless you choose to roll the loan over until your next payday.

Most payday lenders don't consider your credit history, so people with bad credit can still get approved as long as they have a source of income. And many lenders will give you the cash in just a few days, or hours in some cases.

Why they're a bad choice

Payday loans come with steep fees and interest rates -- upward of 300%.

Take a look at Credit.com's list of payday loan laws by state showing the maximum interest rate lenders can charge. Check out some of these terms:

• Alabama -- 17.5%.
• Colorado -- 20% of the first $300, 7.5% for the remainder.
• Louisiana -- 16.75%.

These interest rates may not appear excessive -- they seem similar to credit card rates. But credit cards quote the amount you'll pay over a year, while payday lenders collect their interest in as little as a week. Annualize rates like those above and you're paying triple-digit interest.

Florida law, for example, allows only 10% interest, plus a $5 fee for loans from seven to 31 days. Do that for a year and you could be paying nearly 400%.

It's when the loan gets extended -- called a rollover -- that the fees really add up. Lenders allow customers to extend their loans to the next payday if they pay the fee plus any accrued interest. The borrowers become trapped in a loop of paying fees and interest because they aren't paying down the principal. According to the Pew report, fewer than two out of 10 borrowers can afford to pay off the average loan when it comes due.

Average borrowers end up taking five months to pay off a loan, the report says, paying $520 in finance charges for loans averaging $375.

Why do we allow this?

While the industry claims that "short-term credit products are an important financial tool for individuals who need funds to pay for an unexpected expense," there's evidence that people can survive without them. From the Pew report:

"In states that enact strong legal protections, the result is a large net decrease in payday loan usage .... In states with no stores, just five out of every 100 would-be borrowers choose to obtain payday loans online or from alternative sources, while 95 choose not to use them."

There's been an effort in some states for years to regulate payday loans. We previously reported that payday lender Advance America closed all 47 of its locations in Arizona after a law passed limiting interest to an annualized 36%.

What's the alternative?

The irony revealed by the Pew report is that some borrowers end up turning to family and friends for help to repay their loans -- something they could have done and avoided the payday loan in the first place.

The Center for Responsible Lending offers other alternatives, including:

• Working out a payment plan with creditors.
• Asking for an advance at work.
• Using community-based emergency assistance programs.
• Applying for a loan from a credit union or small consumer finance company.
• Getting a credit card cash advance.

The long-term solution is not living paycheck to paycheck -- obviously tough for the working poor to do.

Using a financial windfall like a pay raise or a tax refund is a good way to start getting yourself out of the trap. And there are plenty of little ideas that could add up.

Some of my favorite ways to trim spending include:

• Start with the little things. Whether it's beer, cigarettes, the lottery, lattes, or junk food, many people blow $5 a day because they think it doesn't matter. It does: $5 a day for a month is $150. Over a year, it's more than $1,800.
• Brown-bag it. It takes planning to bring your lunch to work, but in the long run it's healthier and much cheaper than fast food.
• Buy generic. Many products are the same regardless of the name on the package.

The bottom line

Payday loans may be convenient, but they can be an expensive trap. There are only two ways to improve your situation: make more or spend less.

More on Money Talks News and MSN Money:

• How to stop living paycheck to paycheck
• The 7 dumbest ways to borrow money
• Payday loans: Still popular, still a raw deal
• How to work with a debt collector
• 5 habits to get you out of debt
• Does rent-to-own ever make sense?