How to Break the Cycle of Payday Loan Debt

How to Break the Cycle of Payday Loan Debt article image.

Taking out payday loans can lead to a series of escalating payments that may seem endless. But even if you find yourself feeling trapped, there are options that can help you escape.

The Payday Loan Trap

The Consumer Finance Protection Bureau (CFPB) recently rolled back measures intended to curb payday lending to borrowers without the means to repay, so the costly loans may now be more widely available than ever. Their high interest (equivalent to annual percentage rates of 400% or more), short repayment periods (typically two weeks), and the widespread practice of loan renewals or rollovers can suck borrowers into a costly cycle of loan extensions.

There are two different procedures for extending payday loans, both of which lead to cumulative cost increases. The less severe version entails paying only the interest charge on the loan (or some other fee) on the day repayment is due in full. This extends the loan without paying it down at all; the total amount owed on the original loan is due again, two weeks later.

Under an even costlier alternative procedure, the borrower makes no payment on the original loan's due date (aside from possible fees), and instead takes out a new loan for the sum of the original loan plus the interest owed on that loan—to which a new, higher interest charge is added. Needless to say, that scenario that can escalate debt even more quickly.

A study by the CFPB found that 80% of payday loan borrowers extend their loans at least once, and roughly 12% of borrowers (15% of that 80% majority) end up renewing their loans 10 times or more. Laws in some states limit the number of renewals payday lenders can allow, and payday lenders who belong to the payday lender trade group Consumer Financial Services Association of America (CFSA) limit themselves to four renewals per loan unless local laws impose greater limits.

Potentially compounding the cost of payday borrowing is lenders' common requirement of access to borrowers' checking accounts, and their habit of making multiple withdrawal attempts even if they find the account lacks sufficient funds to pay off the debt. These repeated withdrawal attempts (which had been limited under the now-suspended CFPB regulations) can lead to multiple overdraft penalties that deplete borrower funds even faster.

What Happens if I Default on My Payday Loan?

Worse still, if you miss payments on a payday loan, lenders can be quick to turn the debt over to collections, which creates a negative entry on your credit file that can make it difficult to borrow money in the future.

If you've taken out a payday loan and find yourself in a spiral of growing debt, your situation may feel hopeless, but there are alternatives that can help you get out of the trap. Acting quickly can help you contain costs and find better sources of short-term credit.

Options to Help You Pay Down Debt

Extended payment plan (EPP). Many states require payday lenders to offer EPPs—procedures that let you repay your loan over a longer period of time (typically in four weekly payments). Payday lenders who belong to the CFSA trade association pledge to offer EPPs to any borrower having trouble with repayment, but other payday lenders may not be so proactive.

Debt consolidation loans. The ideal option (aside from avoiding payday lenders in the first place) may be to seek a personal debt consolidation loan. The idea is to borrow money at a relatively low interest rate and use it to repay your payday loan in full, along with other high interest debt you may have, such as credit card balances. You must still repay the personal loan, of course, but the strategy is to arrange predictable (non-escalating) monthly payments that fit in your budget. Personal loans do require a credit check, but they are available even to borrowers with little or poor credit.

Payday alternative loans (PALs). Devised by credit unions to meet the needs payday loans address, but under more reasonable costs and repayment terms, these short-term loans are available in amounts up to $1,000 and they require no credit check. They are designed for use instead of payday loans, but you can use one to pay off a payday loan as well. Maximum interest on them equates to a 28% annual percentage rate, and you can pay it back in equal monthly installments over a period of up to six months. You must belong to the credit union for 30 days (in other words, have an open account in good standing there) to qualify, and may be required to pay an application fee of up to $20.

Peer-to-peer loans. Web-based lending sites that compete with traditional financial institutions don't always check credit scores, but they do typically require evidence of income and other assets that can make loan approval difficult for those with limited or poor credit or fair to poor credit scores. It's worth investigating these sites anyway, especially if you keep the loan amount small (under $5,000). It's easy to apply at multiple sites in a single session, and you'll find out relatively quickly if you qualify. If you do, the loan amount can be transferred to your checking account within a few days.

Debt management plan. If all other options fail and you find yourself unable to pay off a payday loan, consider pursuing a debt management plan (DMP). Under a DMP, you work with a certified credit counselor to come up with a budget and debt repayment schedule, and the counselor may negotiate with payday lenders and other creditors to accept less than the total amount(s) you owe. Participation in a DMP entails closing all of your credit card accounts, and it is noted in your credit reports. Because lenders view it as a severely negative event, pursuing a DMP can hinder your ability to borrow money for several years afterward.

What Do I Do After Getting Out of Payday Loan Debt?

Once you've escaped the quicksand of payday loans, it's a good idea to take steps to avoid needing to resort to them again. You can start by building up an emergency fund. Then check your credit score and start working toward improving your scores, so you'll be more likely to qualify for affordable credit when you need it.

Building up your credit could take several months or even years, so if you need short-term credit in the meantime, look first to payday alternative loans (PALs) from a credit union. If payday loans turn out to be your only option, stick with lenders who belong to the CFSA trade organization to ensure you'll have access to extended payment plans and some level of business standards. But the best payday loans are the ones you avoid.