Payday loans are a high-cost form of unsecured credit where you borrow a relatively small amount of money until your next payday.
When your boiler is racing in the middle of winter or your car breaks down and you have no savings, a payday loan may seem like the only option. Offering same day loans online, these companies can seem like a tempting solution to cash flow problems.
Below, this article discusses:
What are payday loans and how do they work?
With few proper affordability checks, the short-term payday loan industry was once a Wild West, lending indiscriminately to people with bad credit, low incomes, or those on social benefits.
Some borrowers ended up getting caught in damaging cycles of debt, rolling over payday loans with interest rates of 5,000% or more month-to-month until their initial small debts settled. turn into big ones.
In 2014, the financial regulator intervened. The Financial Conduct Authority (FCA) has cracked down on payday lenders with a string of new rules this led to a 35% drop in the number of loans and the amount borrowed in the first five months following the rule change – and resulted in the closure of some payday loan companies.
Regulatory crackdowns have forced payday loan companies to lend more responsibly, with better terms for borrowers.
What this means in practice is that now:
- Interest rates and fees are capped at a maximum of 0.8% per day
- There is a £15 cap on late payment charges
- Loans can only be rolled over twice. Borrowers must pay rollover fees for delaying loan repayment
- There is a total cost cap of 100%. This means that interest, fees and charges cannot exceed the amount originally borrowed. In other words, no borrower will repay more than double what he borrowed.
- Anyone taking out a loan for 30 days will pay no more than £24 in fees and interest for every £100 borrowed
- Lenders can only take up to two payments from customers’ bank accounts through a continuous payment authority, where the lender uses the customer’s debit card details to take the money
- Lenders must verify the affordability of the borrower, which means FCA-regulated companies must carry out a credit check
- Payday loan ads should come with risk warnings and directions for free debt advice
So definitely these products are not as bad as before. But what else should you be aware of before considering a payday loan? Let’s look at the pros and cons.
Read more: ‘I graduated without any debt’
Benefits of Payday Loans
Payday loans have some advantages, although these don’t outweigh the disadvantages, which we’ll get to in a moment.
- You could be approved even if you have a less than normal credit history – if the lender thinks you can afford the repayments
- They are fast. For those who need urgent loans (including urgent loans for people with bad credit history), you can get the money in your bank the same day.
- You can roll over the loan up to twice before paying it back, although you’ll pay more interest to do so
- They are practical. You can apply over the phone and get same day loans even on weekends
But this convenience comes at a cost.
Learn more: How to get a personal loan
Disadvantages of Payday Loans
- They are expensive. Even an interest rate capped at 0.8% can accumulate over the life of the loan. For example, if you take out a loan of £200, the daily interest payment will be £1.60. Multiply that over 30 days and the payout is £48. You’re late with your debt settlement and the daily interest keeps piling up, and you’ll also be stung by the £15 late payment charge
- Regulated companies are required to perform a credit check. Companies offering payday loans may perform a “simplified search” — a less than comprehensive review of your credit history that’s invisible to other lenders — when you apply. Or they may do a “thorough search” – an in-depth investigation that is recorded on your credit file – when you agree to the terms of the loan. Alternatively, there are unregulated companies, which you should avoid as you will have no consumer protection if they go bankrupt.
- They don’t look good. Having payday loans on your credit report can make you look unattractive to more traditional lenders
- Are you looking to buy a house or mortgage? For the reason above, they can ruin your chances of getting a mortgage
- A lender can use the money in your account through a continuous payment authority. It may make two attempts to take these refunds, but, if they bounce, you could end up with bank charges
- You risk being trapped in a spiral of debt where you borrow to pay off your shortfall each payday
Although you can search for the best payday loans, there are more ethical and cheaper alternatives if you are looking for an urgent loan.
Read more: What happens to debts when you die?
Alternatives to payday loans
Here are some alternative payday loans to consider first:
An arranged or authorized overdraft on your current account means that your bank has previously agreed to lend you a certain amount.
Annual interest rates on these overdrafts – the FCA banned banks from daily and monthly charges in April 2020 – vary between lenders by around 15% to 40%.
Under the same FCA reforms, lenders can now charge no more for unarranged overdrafts than for authorized overdrafts.
However, if you are overdrawn without prior agreement, it could affect your credit score and your bank will usually reject direct debit payments or check to see if there are not enough funds in your account.
Read more: Is it better to use an overdraft or a credit card?
This is when you withdraw cash from an ATM using a credit card.
It’s an expensive way to borrow because you’ll usually pay a fee plus interest from the time you make the withdrawal; the average credit card interest rate is 23% per year.
Credit card cash advances are also a warning sign to lenders that you may not know how to manage your money. So having them on your file could hamper your chances of securing future loans at competitive rates.
You can use a money transfer credit card to transfer money from a card to your bank account. You pay an upfront fee, but there will usually be a 0% period during which you pay no interest.
You should therefore treat it as a fixed-term loan and aim to pay off the balance during this period.
A personal loan allows you to borrow a lump sum of money over a fixed period, repaying a fixed amount each month.
It can be a cheaper form of borrowing, with currently very low interest rates. But you will usually need a decent credit history to be accepted for an unsecured loan.
Find out more: Should I take out a bank loan or a credit card?
If you have a poor or limited credit history, a guarantor loan allows you to borrow if you have a friend or family member with good credit who will co-sign as guarantor.
This means they agree to be responsible for repayments if you fail to repay the loan. The risk is that you end up straining your relationship with this person if they have to continue to replace you.
Another thing to keep in mind is that guarantor loans can be expensive, as they are likely to charge higher interest rates than other types of loans. The annual interest rate can usually vary from 25% to 70%, according to figures from the comparison site Gocompare.
Loans for bad credit
There are specific loans for people with bad or short credit history. But the interest rates are very high compared to other types of loan – around 49% on average.
So, if you don’t need to borrow urgently, it’s best to start by improving your creditworthiness so that you can get cheaper loans in the future.
Loans from a credit union
credit unions are an ethical alternative to payday lenders.
Offering affordable loans, even if you have a bad credit history, these syndicates will generally lend without a credit check if you can show that you can afford the repayments.
They may ask you to set up a small amount of regular savings when you take out a loan with them, to reduce your need to borrow again. Usually, credit unions are tied to a local area or to a profession or an employer. You will therefore have to meet their criteria to register.
If you have been receiving certain benefits for six months or more, you may be eligible for a budget loan from the government to cover your essential household expenses.
These loans are interest free, so you only pay back what you borrow. Reimbursements are automatically deducted from your benefits over a period of up to two years.
Find out more: Should I take out a personal loan to build up credit?
Are payday loans safe?
Is there a safe payday loan? While they are certainly much better than they were before 2014, they won’t do your credit profile any good as they will make you look like a risk to lenders. This could prevent you from getting a cheaper loan and mortgage in the future.
Although payday loans seem quick and convenient, they are also expensive and could make a precarious financial situation worse.
With many better options, payday loans should only be used as a last resort.