What is the major downside of a payday loan?

Relying on Fast Cash Can Lead to a Debt Cycle

Even though most payday loans in Canada are to be repaid within two weeks, reports have shown that the average payday borrower stays in debt for a much longer time period. Because of the high fees and interest rate, it’s easy to get caught in a repeat cycle of rolling over the loan for another two weeks, or taking out another payday loan in order to pay off old loans.

For example, let’s say an emergency came up and you needed $200 in cash. If your credit cards are maxed out and you don’t have enough money in your chequing or savings account, you turn to a payday advance lender to get the cash. For a fee, you get the money on the spot which brings you a temporary wave of relief. But come payday, you realize you don’t have enough money to meet your day-to-day expenses plus the cost of the loan.

So, you put down more money to extend the loan, which you hope to pay back by your next payday. However, by this time the amount you owe has increased, making it even more of a struggle to pay off the loan completely. So, you extend the loan once more to buy more time to pay off the loan. And, that’s how the debt cycle starts. As the cycle continues your balance keeps growing, and it could reach a point where you owe more in fees than you do on the outstanding loan.

Instant cash comes with a price, in the form of high fees and interest rates. This method of borrowing money can get expensive, especially if you’ve made a habit out of taking payday loans just to meet your day-to-day expenses. Getting a payday loan may help you get out of a financial jam, but it’s only a temporary solution to a more serious underlying problem.

Payday loans are expensive, charging very high fees that must be repaid in a short period of time. In fact, you could end up paying an effective APR that's upwards of 400% if you take out a payday loan.

Despite this downside, many people use payday loans anyway. And there are some valid reasons for that. Sometimes, not having the money that a payday loan can provide could have worse consequences than paying the fee to borrow. For example, if a payday loan saves you from eviction or repossession of your vehicle and it was your only option, then taking out the loan may actually have been a good move.

But while there are certain circumstances where you may be able to justify paying a high fee to borrow through this method, it's important to keep in mind that it's not the one-time charge that makes payday loans so dangerous. It's the vicious cycle that forces you to keep borrowing more and more money. Keep reading to learn more.

The cycle of payday debt

The major problem with payday loans is that you have a very short time to repay the entire amount that you owe. In fact, you usually only have a few weeks at most to come up with the full value of the loan. This is a far cry from traditional personal loans, which you can pay back over multiple years.

Unfortunately, if you've been forced into taking out a payday loan, there's a very good chance that you're already stretched pretty thin financially. Taking out this kind of loan means you're committing a future paycheck to making a large lump-sum payment, which is likely to cause you a lot more problems.

Once payday comes around, you may not have the money to cover the full cost of the loan so soon. This is especially true for people who haven't had a lot of time to catch up from whatever financial crisis caused them to need the payday loan in the first place.

If you can't cover the loan, you might end up needing to borrow again -- and paying a second costly fee. People who use payday loans typically keep falling further and further behind this way, with the fees adding up to a real fortune.

Even if you can pay off the loan right away, this is likely going to eat up a large enough chunk of your check. When that happens, you could soon find yourself running short of funds again soon after and thus taking out another payday loan. Plus, that means paying the high fees a second time -- and possibly a third, a fourth, and so on.

Basically, the problem boils down to the fact you're committing future income to covering a current crisis plus a payday loan fee. This increases the likelihood you'll be trapped in an ongoing cycle of taking on expensive payday debt. That's why the Consumer Financial Protection Bureau found that most short-term loans ended in a reborrowing chain of at least 10 loans.

What can you do to avoid this cycle?

Ideally, you'll be able to avoid payday loans so you don't get trapped in this cycle. You can prepare for that by saving up an emergency fund. Your tax refund or your stimulus checks could serve as the start of this fund and give you at least some money for surprise expenses.

If you can't save up an emergency fund, then look into other options such as payday alternative loans from credit unions. Compared to a payday loan, these come with lower fees and longer repayment periods.

But if you do have to take a payday loan, do everything you can to avoid reborrowing, even if you need to work a side job or cut back on expenses before repayment comes due. This way, you can avoid falling deeper into debt.

You can also look into government resources that might be able to help you cope with a financial crisis. And if you find yourself in a reborrowing cycle, know that you aren't alone -- you're one of many trapped in a vicious cycle. For more resources and ideas to help you avoid payday loans, check out our guide on how to pay off debt.

What is the downside of payday loan?

What is the biggest problem with payday lenders?

What are the advantages and disadvantages of a payday loan?