What are Payday Loans? 7 expert reasons to avoid them

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  • With the cost of living rising, you may be wondering what payday loans are and if they could be a solution to ease the pressure on your household finances.

    With the prices of everything rising these days, many of us are looking for ways to save money on groceries and worry about how much our energy bills are going to cost. While a payday loan might seem like a simple solution, it could make your money worries worse.

    Myron Jobson, Senior Personal Finance Analyst at Interactive Investor, explains, “It’s easy to see why these loans can be tempting at first glance, especially when they’re so quick and convenient,” he says. “But while taking out a payday loan to plug holes in your finances may seem like a quick fix, all too often it can land people in a cycle of debt.”

    What are Payday Loans?

    Payday loans are short-term loans for small amounts of money that allow you to carry on until your next payout. You can usually borrow between 100 and 1,000 euros. The idea is that you pay back the money within a month. Some lenders often give you three to six months to repay the loan.

    Sarah Kohl, senior personal finance analyst at Hargreaves Lansdown, says the catch is that they’re notoriously expensive. “The interest rate is a penalty and if you miss payments, the costs will increase at an alarming rate.”

    According to the Financial Regulator (FCA), the average annual percentage rate (APR) for a payday loan is 1,250%. However, for loans intended to be repaid over months rather than years, an APR is pretty meaningless.

    For a better indication of costs, consider cost caps, which limit the amount payday lenders can charge. These were introduced by the FCA in 2015 following a campaign by Labor MP and anti-payday loan campaigner Stella Creasy:

    • Lenders can’t charge you more than 0.8% interest per day – that’s 80p for every £100 borrowed. The maximum fee for a 100 euro loan over 30 days is therefore 24 euros.
    • You cannot be charged more than £15 for missing a payment.
    • You will never be asked to repay more than double the amount borrowed including fees.

    These measures have gone a long way in limiting the potential for payday loans to spiral out of control. But this remains a very expensive way of borrowing.

    Payday loan providers are also controversial.

    Labor MP Stella Creasy launched a campaign against payday loans from 2012. She urged the government to cap costs as some companies offered loans with interest rates as high as 4,000%. In 2014, the FCA investigated Wonga and placed a qualified person at the company to help revise its practices. But by 2018, Wonga had gone bust after a spate of compensation claims from clients who were sold expensive loans. QuickQuid’s parent company was also placed under receivership in 2019 after refusing to pay damages claims.

    Are Payday Loans Damaging Your Credit?

    Taking out a payday loan could hurt your credit score. As a form of credit, payday loans appear on your credit report. Your credit report gives potential lenders an overview of your credit history. It tells you how much debt you have and if you’ve ever missed or been late on any payments. Even if you don’t miss any payments, payday loans can still lower your credit score.

    John Webb, Senior Consumer Affairs Executive at Experian, explains: “Borrowing a lot of short-term borrowing can reduce your credit score by up to 12 months. Your credit score is also calculated based on the average age of your accounts, so many new accounts can affect your score.”

    In theory, by paying off a payday loan in a timely manner, you could improve your credit score over time. However, since payday loans indicate that you are struggling with money, lenders don’t like to see this on a credit report.

    Experian’s John Webb adds: “Some lenders are nervous about this type of loan. If you plan to apply for a mortgage in the future, it makes sense to avoid short-term loans for at least a year.”

    Are Payday Loans Safe?

    Payday loans are risky. Even with regulated lenders, payday loans are risky, although there will be some consumer protection. Interest rates are sky high, there are penalties for missed payments and even with FCA price caps, you could still end up paying double what you borrowed. That’s bad news if you’re already struggling to make ends meet, and makes it all too easy for borrowing to become a habit.

    According to the Competition and Markets Authority, 75% of payday loan borrowers take out more than one loan per year, with the average borrower taking out six loans per year.

    Never borrow from a lender that is not regulated by the FCA – You are effectively dealing with a loan shark.

    7 reasons to avoid payday loans

    Payday loans are legal and, provided the lender is regulated by the FCA, offer some consumer protection. If your boiler is down, they might feel like a lifeline. However, they are still a high risk.

    Here are 7 reasons to avoid payday loans:

    1. They are expensive – a £100 loan for 30 days will likely cost you £24
    2. If you miss a refund you will be charged up to £15
    3. It’s easy for debt to spiral. If you have to borrow money this month, how confident are you that you will be able to pay back the loan plus interest next month?
    4. They could affect your ability to borrow later. Missed payments lower your credit score, while many lenders disapprove of any evidence of payday loans on your credit report.
    5. You can get a loan in minutes – which makes borrowing all too easy without really thinking about it. This often means that you don’t tackle your financial problems at the root or look for alternatives.
    6. You may find cheaper or even free options to borrow.
    7. A payday lender may not have your back. 25% of Step Change clients said their payday lender failed to take adequate steps to ensure they could pay off their loan. When customers reported to their payday lender that they were struggling with repayments, less than 50% reported receiving free debt counseling.

    What is a better alternative to a payday loan?

    Choosing an alternative to a payday loan depends on your circumstances. If you have good credit, using a credit card may be an option. Informal borrowing from parents or other family members can also be a solution. Another option would be a loan from a credit union. These are financial cooperatives that offer low-cost, non-profit savings and loans. Find out if there is one credit union in your area or that serves the industry in which you work.

    Personal finance analyst Sarah Coles says, “If you need money for a specific purchase to get you by payday, you can use a regular credit card to borrow interest-free until the day you pay. As long as you pay it off in full at that point, it won’t cost you anything. If you need to borrow longer and qualify for a credit card with 0% on purchases for a period of time, you can borrow interest-free. Just make sure you calculate exactly how you’re going to pay the money back before interest is charged.”

    It’s usually best not to borrow unless you really have to. Instead, look for ways to cut back on your spending wherever possible. It’s difficult to save on gas and heating bills right now, but you might be able to go to a cheaper supermarket or forgo the remaining luxuries. Creating a monthly budget detailing all of your income and essential expenses is a good place to start.

    What should I do if I have a payday loan?

    If you already have a short-term loan, it is best to repay it as quickly as possible – without taking out another short-term loan. The longer it takes you to repay the loan, the more it will cost you. If you miss payments, you will also be stung with penalties.

    In many cases, examining your finances and creating a budget can be enough to regain control of your money. However, if that is not enough, it is worth turning to a charity such as progress or National Debt Limit for a free debt consultation. The sooner you act, the easier it will be to get back on track.

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