A Dangerous Way To Deal With Debt

Steer clear of payday loans.

This article was first sent to Fools as part of our 'The Good, The Bad and The Ugly' email series. 

If you were asked to name an unwelcome American import to the UK, it's doubtful that payday loans would be the first thing on your mind. Nevertheless, this truly ugly form of borrowing is over-priced, over-used and over here. Increasing numbers of Brits are falling victim to this form of borrowing - when they should be fleeing from it.

What are they?

Payday loans are cash advances on the salary you're expecting at the end of the month. They're paid back to the lender once you've received your wages.  Often, payday loans firm will require you to write a post-dated cheque which will be cashed when your salary clears into your bank account.

They've proved very popular in the US, where it's estimated that more than 10 million people have used them to borrow billions of dollars.

In the UK, dozens of online payday loans firms have sprung up. They promise to pay amounts of up to £1000 direct to your account within an hour of your application being processed. They're easy to get - you just need to be over 18 with a bank account that receives regular payments from an employer.

At first glance, payday loans look great. I suspect most of us have, on occasion, run out of money  a few days before pay day. So these loans might be the answer to your mid-month prayers.

So what's wrong with them?

The first foul feature of payday loans is their exorbitant rates of interest. In a typical transaction, a customer might borrow £200 over thirty days for a fee of £50 - so the total due on pay day would be £250.

That's an interest rate of 25% for just a month - and equivalent to an APR of over 2000%!

Perhaps this is an extreme way of looking at payday loans; after all, they're meant to extend over weeks, not years. But it does expose how expensive they really are. In comparison, most personal loans have typical APRs of under 8%.

Clearly, payday loans are a far from Foolish way to borrow.

What's worse is that users often don't stick to the single-month repayment period originally agreed. With many websites offering payday loan `roll overs' at the click of a button, it's all too easy to extend the term of your borrowing - thus incurring extra fees and interest charges.

Payday loans are products that can easily push people with existing problems into a downward debt spiral.

Who's using them?

Perhaps it's no surprise that users of payday loans tend to be young and naive about how to handle their money. Often these users find it hard to get credit elsewhere.

According to the Consumer Credit Counselling Service, the number of under-30s with problem debts is on the rise - and growing numbers of them are struggling with payday loans.

What are the rules?

In the US, payday loans have so worried authorities that several states have introduced stringent regulation or banned them completely.

Over here, however, there is little to restrict the activity of payday lending firms. While the British Cheque Cashers Association (BCCA) has drawn up a Code of Practice for its members which strongly discourages the excessive rolling over of payday loans, membership - and thus adherence to these rules - is voluntary. Moreover, the BCCA covers only high street, not online, providers of payday loans.

I think something must be done to regulate payday lending in the UK - and fast. With the credit crunch now biting, even people who would ordinarily borrow more sensibly could be tempted by these ugly, yet easily-accessible, products.

What are the alternatives?

If you need to borrow a small amount of money over a relatively short period, there are much better ways. Credit Unions typically offer loans at APRs of around 12.7%, and there are hundreds throughout the UK.

Alternatively, the Bank of Mum and Dad/Partner/Spouse is a tried and tested source of emergency cash. Eating a slice of humble pie definitely beats swallowing the crazy cost of a payday loan.

And even if you have a chequered past, there are credit cards you can apply for. Take a look at the Capital One Bank Classic Visa and the SAV Credit aqua MasterCard. Their interest rates are high but lower than a payday loan. And if you just use the card for spending and pay off the balance in full a month later, you won't pay any interest.

Better still, it will allow you to build up a positive credit history. That said, given the problems with the credit crunch, I can't guarantee that any application for a credit card will be successful.

Of course, the best answer is to budget. Try to keep a close eye on your spending so that your pay cheque can last the whole month.

I think payday loans are a hideous product of our `buy now, pay later' culture, and they're an especially dangerous way to paper over the cracks in your financial planning.

If you're struggling with debts, take a look at The Motley Fool's Get Out Of Debt articles and our Dealing With Debt discussion board.