Debt trap: Breaking free from the cycle of payday loans

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Benjamin John Coleman wants to ban payday loans from Rhode Island because he knows what it feels like to be desperate enough to take one out.

Even though he never had a payday loan.

Coleman, who has been in recovery for four years, said he turned to short-term credit six years ago to simply get money for drugs. "I didn't care what the interest rate was," he says.

His credit fix was a title-loan on his home, a camper trailer. He lost the trailer, but eventually turned his life around. Now Coleman helps other people who are trying to recover from drugs — and works on getting rid of what he considers another addiction: payday loans. He is a volunteer who helps update the website RIPayday.org, an organization seeking to ban payday loans from Rhode Island.
But not everybody who uses payday loans is desperate. In tough economic times, more people are turning to payday loans for temporary help — even if they have good salaries. A recent survey by Think Finance found Millennials making between $50,000 and $74,000 were 7 percent more likely than Millennials who made less than $25,000 to take out a payday loan.

What Coleman is hoping to do in Rhode Island has already happened in other states. Arizona's effective ban on payday loans went into effect in July 2010, for example. Santa Clara County, Calif. limited the number of payday loan stores in May.

But not everybody is opposed to the loans. The Pennsylvania Senate is considering legalizing payday lending after approval by the State House. By comparison in Utah, according to the Department of Financial Institutions, lenders can't allow a rollover of a loan beyond ten weeks from the initial execution date of the loan. Borrowers can make payments on loans in $5 increments or more without incurring any additional finance charges. 


At the center of the debate is what critics call the payday loan debt cycle. It works like this: People don't have enough money to pay their bills so they take out a payday loan. When they get their next paycheck, they pay back the entire loan plus fees that are equivalent to triple digit annual percentage rates. This, unfortunately, leaves them without enough money to pay their bills, so they take out another payday loan. Wash. Rinse. Repeat.

But is this a situation unique to just payday loans?

Richard W. Evans, an assistant professor of economics at BYU, who says he did some consulting work for payday lenders back in 2009 and 2010, doesn't think so.

"You do see people abuse these loans," Evans says. "But that is not specific to the payday lending industry. You can find people who 'can't handle their liquor' in mortgage markets, in credit card markets — in any debt market you have people who over borrow."


Here is your typical person who takes out a payday loan according to the Consumer Federation of America's national expert on payday lending, Jean Ann Fox: They have a low to moderate income. They have to have a bank account to be eligible for the loan. They have to have a source of income. "Consumers who use payday loans are not the most destitute in society," Fox says. "They are banked and they have a source of income."

Why are they taking out the loans?

Nathalie Martin, a professor at University of New Mexico's School of Law, and an expert on consumer law, bankruptcy and predatory lending products, says her studies show most people are taking out payday loans not for emergencies, but for regular monthly obligations. "It just creates a situation where next month or two weeks from now they have another bill to pay," she says. "I think people are far better off without this type of credit."

A study by the Center for Responsible Lending showed that 76 percent of payday loans were taken within two weeks of another payday loan — meaning that three-fourths of the loans were from people in the payday loan debt cycle.

For Evans, banning payday loans would be like banning credit cards because some people do not use them responsibly. The question is not one of banning, but of personal responsibility and freedom. The problem is not unique to payday loans.

Evans says payday loans are part of a continuum of different debt products — ranging from 30-year mortgages to installment loans for furniture. There are credit cards, revolving credit, payday loans, title loans, payday loans and so forth.

And payday loans are very transparent, Evans says. "It's just a simple transaction," he says. "You go in. You borrow $300. And then you go back and you pay back $300 plus $45 in two weeks. That's the basic transaction."

But it is the easiness and simplicity that bothers Fox with CFA, "The easy solution of walking into a payday loan store and writing a check when you don't have money in the bank and promising to pay it all back out of your next paycheck at triple-digit interest rates, to keep that check from bouncing and triggering overdraft fees, — that is not a solution," she says. "It adds to your problems."


Payday lending isn't everywhere. Some states allow the loans with few regulations. Others put on various restrictions that are aimed to break the debt cycle — such as limiting the number of consecutive loans. Others have banned them outright or lowered the interest rate so they are not profitable to lenders.

"Payday lending, the way the industry wants to do it, is only legal in 37 states," Fox says. "About a third of the population of the United States live in a state that does not authorize single-payment, triple-digit-interest-rate loans."

North Carolina's payday laws were allowed to expire, ending the practice — and making an opportunity to see how ending payday lending affected people. But when a state ends payday loans, such as North Carolina, Evans says the results are mixed. "There is evidence on both sides," he says. "Some studies say that when payday lenders were banned, delinquencies and bankruptcies went up. Others showed that the (area) with payday lenders had more delinquencies. So it is an open question."
Martin agrees that the studies are not clear. "Some show people are better without this," she says. "Some show people are better with this. So they are really inconclusive."

The Community Financial Services Association of America, a trade association for payday lenders, says on its website that studies don't show a payday cycle because the number of times a customer can take out a loan is limited in most states. CFSA member lenders also offer extended payment plans at no extra cost if the borrower can't pay back the loan in time. "The vast majority of Americans, undeniably, use payday advances responsibly and, as intended, for short-term use," the CFSA website says. "State regulator reports and public company filings confirms that more than 90 percent of payday advances are repaid when due and more than 95 percent are ultimately collected."
But whether there is a cycle or not, how are those fees eventually collected?

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Fox says up to 50 percent of the people taking out payday loans eventually default. "They just can't keep it up," she says.

If they default, they rack up bounced check fees. They may lose their bank account. Lenders initiate debt collection.

In other cases, people use their tax refund to pay it off.

People may go to their family for help.

People ask for help from churches. They've gone to credit counseling. They go to food banks and use the money they save to pay off the loan.

They may go for a larger loan, which puts them in a different type of trouble, Fox says.

Andrew Schrage, co-owner of Money Crashers Personal Finance (MoneyCrashers.com), says in extreme cases, people can always file for bankruptcy. "But keep in mind that this ruins your credit score, which takes years to rebuild," he says.

Schrage says one way out may be to generate more income. "You can conserve energy to reduce your monthly bills," he says. "Sell your unneeded electronics online, have a garage sale, start a side business — the possibilities are endless."


Evans list of alternatives to taking out payday loans isn't pretty. "One product people move into is to overdraw their bank account and then pay those fees," Evans says.

Bankruptcy is another "option."

People can borrow on a credit card.

They can do installment loans or collateralized loans (like title or pawn loans).

People can borrow against their home equity.

Each of these loans has a different maturity and level of collateralization, Evans says.

Fox says the first line of defense against using payday loans is an emergency savings account. 

"People say they can't afford to save money," she says, "but you can't afford to pay $75 to borrow $500 every payday either."

Fox says for a family making $25,000 a year, just $500 in an emergency savings account will make it eight times less likely they would take out a payday loan, she says.

The best time to set aside an emergency fund is during tax season when people get their earned income tax credit and child tax credit. Then, if there is an emergency or an interruption in income, people can borrow from themselves and pay themselves back when they can. This puts less stress on a family than borrowing that money and having to pay it all back on the next paycheck with fees.
Lower cost small dollar loans are sometimes available at credit unions.

"(When payday loans are not available) people do what you do when you run short of money," Fox says. "They juggle their finances, ask their family for help, ask for more time to pay their bills, ask for an advance on their next paycheck — the things people have always done when they have trouble making ends meet."

Schrage thinks a personal loan from family or friends is the best resource for help in lieu of payday loans. "If you can secure a loan from a friend or family member, do yourself a favor and put the agreed upon terms in writing to protect both parties," he says. "Also, whatever terms are agreed upon, stick to them as best you can. This way, your loan won't have any negative effects on your personal relationships."

There are also short-term credit union loans. "Some credit unions offer short-term loans with better rates than payday loans," Schrage says.


And there are always credit cards.

"It is certainly much less expensive to take out a cash advance on your credit card — it is still pricey, but it is much less expensive than getting a payday loan that has to be paid back at one time," Fox says.

But, surprisingly, a study in the May 2009 American Economic Review on "Payday Loans and Credit Cards" found that "most borrowers from one payday lender who also have a credit card from a major credit card issuer have substantial credit card liquidity on the days they take out their payday loans."
In other words, they could have borrowed that money on their credit cards at a much lower interest rate.

Why don't they? Evans thinks a payday loan forces people to pay back the money sooner. "They are committing themselves to pay it off," he says.


Martin thinks the problem is financial literacy and a general culture of immediacy. "The real problem is people are not aware of how much money is coming in and how much is going out," Martin says.

Schrage agrees.

"Your best bet is to simply take control of your finances so that a payday loan is never a necessity," he says. "Create a personal budget for yourself, and commit to spending less than you make. Cut costs wherever you can, and try to generate more income, either on the side, or by working more hours at your day job."

Fox still sees payday loans as a trap — saying there is usually not enough money to pay back a payday loan in two weeks — even if the loan is free. "You don't solve a debt problem with more debt," Fox says.

Evans, however, says payday loans are no worse than any other type of debt if used responsibly. "In any debt product, there is a risk of getting into a debt spiral," he says. "In the United States, you and I have the liberty to take on more debt than we can handle. The risks of payday loans are not any greater, and are probably less than other lending products."

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