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How Payday Loan Costs Can Spiral

Much has been written in recent months about one of the most quickly growing areas of personal finance: payday loans.

While these loans can certainly be of use in filling a temporary lack of cash before your next payday arrives, and this is how they are marketed in smiley, fluffy TV ads promising quick cash to resolve an emergency - and this is how the lenders would like you to see the industry - the reality is often much darker.

Not only are payday advances right at the top end of finance in terms of cost, they have a very dangerous problem which, whatever claims the loan issuers make, has been very profitable indeed to the detriment of the borrowers.

How It Works

The basic premise of payday finance is very simple: you get fast access to cash, and for every £100 you borrow you need to repay something like £120 when your payday comes around. On the face of it this looks reasonable, equating to roughly 20% interest on your loan, when very many credit cards have percentage figures of at least this amount.

Caught In A Trap

The problem comes when you consider that the two figures aren't comparing like for like. With a credit card, the interest rate is what you'd pay over a full year - so borrowing £100 for a year at 20% APR you'd have to repay £120.

With payday loans, you'd have to pay back the £120 within a month. If you couldn't afford this, you'd have to roll over your loan for an extra month, by borrowing the £120 you should have repaid. The month after, this £120 would need to be repaid along with another 20% fee - i.e. your £100 debt is now £144. We're already up to 44% interest after a single extension of the loan. Keep this up for a few months and you can see how the amount you owe can quickly get out of control, with interest calculated under the same method as for credit cards often exceeding 2000%. This was a goldmine for the more unscrupulous lenders.

Controls

So what can be done? For a start, regulators have recently introduced a limit to how many times you could roll a loan over, after which you'd have to repay the full debt or come to an affordable repayment plan with the lender.

Some people got around this by playing loan companies off against each other, rolling loans over to the maximum amount and then going to a different lender (or more than one) to get a new loan to pay off the old one, then starting all over again. There are moves afoot to defeat this by requiring lenders to pool their data and not lend to people who already have active loans elsewhere.

All said, once you get into the habit of rolling over payday loans it can become extremely difficult to escape the spiral, so if you decide you really need to take one out, make sure you can pay it off in full the month after, or at least a sizeable amount of it so you won't get caught in the payday trap.



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