A payday loan is a short-term, unsecured loan. Payday loans are usually issued for a two-week term and offer a quick cash solution for people needing cash. They are often used by people who need money for unexpected expenses.
The term “payday” is often used to describe when employees receive their wages and payday loans are due. Payday loans are designed to be repaid in full on the date specified in the contract. If the loan is not paid by that date, the borrower will face significant financial penalties and a high-interest rate.
How does a Payday Loan Work?
Payday lenders typically offer this type of loan to those with a steady income and a bank account but no credit history. The lender will approve the loan based on the borrower’s employment information, bank statements, and other financial information.
The borrower will then receive the funds in their bank account as soon as they apply for the loan, automatically deducting repayments from their next paycheck. Payday lenders often charge high rates of interest and require repayment on a short-term basis.
Suppose you need a payday loan. The process would be that you would write a cheque to the lender for the amount of the loan plus the interest. Then, you would put the date on the cheque of the day in the future when you will receive your paycheck. The payday loan firm will hold the cheque until that time and encash it because your salary account would have sufficient funds. After you provide this cheque to the payday loan firm, it provides you with the loan in cash or by transferring the funds into your savings account.
Assume that you need Rs 50,000 for some immediate purpose but do not have any money until you receive your paycheck one week from today. You provide the payday loan firm with a cheque one week from today. The payday loan firm may charge an amount of Rs 5,000 over the loan amount. This amount of Rs 5,000 would be termed as interest, and in terms of percentage, it would be 10% for taking a loan for one week. The financing cost of a payday loan could be huge or, in other words, draconian.
In the above example, the cost of financing a payday loan of Rs 50,000 on an annual basis would be:-
Cost of Financing = 10% * (number of days in a year/ number of days in which you have the loan)
= 10% * (365/7)
= 521%.
Points of Caution in a Payday Loan
Firstly, using your next paycheck to cover a loan may not have sufficient funds to make regular monthly purchases after repaying the loan. Thus, you may need another loan to protect your assets in that period, creating a continual cycle in which your paycheck would be required to repay short-term loans.
Secondly, 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 could get a loan that charged you a more reasonable rate such as 10% annually.
Interest rate for a 7 days period = 10% * (7/365) = 0.192%.
The interest would be just Rs 96/- (Rs 50,000 *0.192%). Thus, you would pay less than Rs 100 as interest on a seven-day loan if you were charged a 10% annualized interest rate. This is substantially less than the interest a payday loan firm would charge you. The payday loan firms can 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.
Conclusion: Avoid the Dangers of Payday Loans
Payday loans are not a desirable financial instrument to have. They can cause a lot of problems, including bankruptcy and even homelessness.
The first step in avoiding the dangers of getting a payday loan is to avoid taking one out in the first place. You should only take out a payday loan if you have to, and you should only take out what you know you can pay back with your next paycheck.
You should never take out more than one payday loan at a time and never borrow more than two weeks’ worth of income from them. If you do this, you will be able to avoid the dangers of getting a payday loan and the risks of taking one out.
