A payday loan is a short-term loan provided to you if you need funds in advance of receiving
your paycheck. To obtain a payday loan, you write a check to the lender for the amount of the loan plus the interest. You date the check for the date in the future when you will receive your paycheck. The payday loan firm will hold the check until that time and will cash it then because your checking account will have sufficient funds. After you provide this check to the payday loan firm, it provides you with your loan in cash or by transmitting funds into your checking account.
Assume that you need Rs 50,000 for some immediate purpose, but will not have any money until you receive your paycheck one week from today. You provide the payday loan firm a check dated one week from today. The payday loan firm may request that your payment be Rs 55,000, which reflects the loan of Rs 50,000 and Rs 5,000 interest and/or fees. You are paying Rs 5,000 more than the loan you received, which reflects 10% of the loan amount.
The cost of financing a payday loan follows:
Cost of Financing = 10% * (number of days in a year/ number of days in which you have the loan)
= 10% * (365/7)
You should avoid payday loans for the following reasons.
First, by using your next paycheck to cover a loan payment, you may not have sufficient cash available to make normal purchases after covering the loan. Thus, you may need another loan to cover your purchases in that period, and this can create a continual cycle in which your paycheck is always needed to repay short-term loans.
Second, as we have seen, the cost of financing with a payday loan is outrageous.
Consider how much you would have paid in interest on Rs 50,000 if you were able to get a loan that charged you a more reasonable rate such as 10% annually.
Interest rate for a [email protected] period = 10% * (7/365) = 0.192%.
The interest to be paid = Rs 50,000 *0.192% = Rs 96. Thus, you would pay less than Rs 100 interest on a seven-day loan if you were charged a 10% annualized interest rate. This is substantially less than the interest you would be charged by a payday loan firm. The payday loan firms are able to charge excessive rates because some people who need money quickly may not be creditworthy and therefore have difficulty obtaining funds from other sources. Alternatively, some borrowers do not realize how high the cost of financing is when they borrow money from a payday loan firm.