What is a payday loan? 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 strain on your household finances.
With the price of everything rising these days, many of us are looking for ways to save money on food and worrying about the cost of our energy bills. Although a payday loan may seem like an easy 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 cover holes in your finances might seem like a quick fix, it can too often trap people in a cycle of debt.”
What is a payday loan?
Payday loans are short-term loans for small amounts of money that keep you going until your next payment. You can usually borrow between £100 and £1,000. The idea is that you repay the money within a month. Some lenders will often give you three to six months to repay the loan.
Sarah Coles, senior personal finance analyst at Hargreaves Lansdown, says the catch is that they’re notoriously expensive. “The interest rate is penalizing and if you miss payments, the costs will increase alarmingly.”
According to Financial Conduct Authority (FCA), the average annual percentage rate (APR) on a payday loan is 1,250%. However, for loans that are meant to be repaid over months rather than years, an APR doesn’t make much sense.
For a better indication of costs, consider the cost caps that limit the amount payday lenders can charge. These were introduced in 2015 by the FCA, following a campaign by Labor MP and campaigner against payday loans Stella Creasy:
- Lenders cannot charge you more than 0.8% interest per day, or 80 pence for every £100 borrowed. The maximum charge for a loan of £100 over 30 days is therefore £24.
- 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 charges.
These measures have gone a long way in limiting the risk of payday loans spiraling out of control. But it’s still a very expensive way to borrow.
Payday lenders are also no strangers to controversy.
Labor MP Stella Creasy, launched a campaign against payday loans from 2012. She urged the government to cap costs as some companies were offering loans with interest rates of 4,000%. In 2014, the FCA investigated Wonga and placed a qualified person at the company to help review its practices. But in 2018, Wonga went bankrupt following a deluge of compensation claims from customers who were sold high-cost loans. QuickQuid’s parent company also went into administration in 2019 after refusing to pay compensation claims.
Are payday loans hurting your credit rating?
Taking out a payday loan could potentially hurt your credit score. As a form of credit, payday loans will show up on your credit report. Your credit report gives potential lenders insight into your borrowing history. It tells them how much debt you have and whether you’ve ever missed or made late payments. Even if you don’t miss payments, payday loans can still lower your credit score.
John Webb, senior consumer affairs executive at Experian, explains, “Taking a lot of short-term loans can lower your credit score for up to 12 months. Your credit score is also calculated based on the average age of your accounts, so having a lot of new accounts can impact your score.
Theoretically, paying off a payday loan quickly could increase your credit score over time. However, because payday loans suggest you’re struggling with money, it’s not something lenders like to see on a credit report.
John Webb of Experian adds: “Some lenders are nervous about these types of loans. If you want to apply for a mortgage in the future, it’s a good idea to avoid short-term loans for at least a year.
Are payday loans safe?
Payday loans are high risk. Even with regulated lenders, although there is some degree of consumer protection, payday loans are risky. Interest rates are exorbitant, there are penalties for missing payments and, even with FCA price caps, you could still end up paying double what you borrowed. It’s bad news if you’re already struggling to make ends meet and it’s too easy to borrow to become a habit.
According to the Competition and Markets Authority, 75% of personal 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 not regulated by the CIF – you are indeed 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 may seem like a lifesaver. However, they are still high risk.
Here are 7 reasons to avoid payday loans:
- They are expensive – borrowing £100 for 30 days will probably cost £24
- If you miss a refund you will be charged up to £15
- It is easy for debts to skyrocket. If you need to borrow this month, are you sure you can repay the loan plus interest next month?
- They could affect your ability to borrow later. Missed payments will lower your credit score while many lenders will frown on any evidence of a payday loan on your credit file.
- You can get a loan in minutes, which makes borrowing too easy without thinking about it. This often means you don’t end up getting to the root of your financial problems or looking for alternatives.
- You may be able to find cheaper or even free ways to borrow.
- A payday lender might not support you. 25% of Step Change charity customers said they didn’t think their payday lender took reasonable steps to ensure they could repay their loan. When customers told their payday lender they were having trouble paying, less than 50% heard about free debt advice.
What is the best payday loan alternative?
Choosing an alternative to a payday loan depends on your situation. If you have a good credit rating, using a credit card may be an option. Borrowing informally from parents or other family members can also be a solution. Another option could be a loan from a credit union. They are financial cooperatives that offer low-cost, non-profit savings and loans. Find out if there is a box near you, or that serves the industry in which you work.
Sarah Coles, Personal Finance Analyst, says, “If you need money for a specific purchase to get you through payday, a normal credit card will let you borrow interest-free until the payday. payment. As long as you pay it off in full at this 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, you can borrow without interest. Just be sure to figure out exactly how you will pay the money back before interest is charged.
As a general rule, it’s best not to borrow unless you really have to. Instead, look to find ways to reduce your expenses wherever possible. It’s hard to save on gas and heating bills at the moment, but you might be able to head to a cheaper supermarket or cut down on remaining luxury expenses. Writing a monthly budget showing all your essential income and expenses is a good start.
What should I do if I have a personal loan?
If you already have a payday loan, the best thing to do is to pay it off as soon as possible – without taking out another short-term loan to do so. The longer you delay repaying the loan, the more it will cost you. If you miss payments, you will also be stung with penalties.
In many cases, putting your finances under the microscope and writing a budget can be enough to get you back in control of your money. However, if that’s not enough, it’s worth contacting a charity such as Stage change or National debt line for free debt advice. The sooner you act, the easier it will be to get back on track.
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