InDebted Explainer: Understanding short-term loans
This article is part of the series InDebted — South Carolina Public Radio's deep dive into the ecosystem of debt in the Palmetto State.
Do you have options? Financial ones, I mean. Like, if your tire blew or the baby broke out in a rash and you needed $500 to get the situation fixed, would you be able to get it from your bank account? Put it on a credit card? Borrow it from mom?
And if you couldn’t, if your bank account were an absurdist farce and your credit rating wouldn’t even be an acceptable SAT score, where would you go to get money? You can’t just lose your job because of a blown tire, after all, right? And it’s not like you can just let a baby suffer a rash like it’s going to go away on its own.
So where do you get that money?
This is the calculus on which short-term lending thrives. Payday lenders, auto title lenders, other installment lenders — these are the places that say yes when everyone else says no. Colorful, storefront lenders, right down the street, who will lend you money in a hurry, in a pinch, that you agree to pay back over a short period of time.
Crucially, you also agree to pay it back with a lot of interest, or you pay an upfront fee for a payday loan.
Understanding short-term loans can get a little confusing. So let’s look at the different types of short-term, small-dollar loans you can get.
The word “payday” is a lot like the word “Kleenex.” It’s a phenomenon called (and I admit I like any excuse to use this phrase) “brand lexicalization.” It’s when you use a brand name to stand in for a product or service itself. You do it when you google (not web search) something or you ask for a Kleenex (not a tissue) when you sneeze.
When people talk about short-term and small-dollar lending, they usually just call them payday loans, even if they’re a completely other type of loan.
But what separates payday loans — which generally do not require credit score checks prior to receiving them — from all other types of loans is that they don’t come with interest. Payday loans come with an upfront fee — $15 for every $100 you borrow — and the payback term is only about two weeks.
“This is until your next payday,” says Audrey Williams, a former, longtime payday loan agent in Aiken. “It’s not a monthly loan. It’s to your next pay date.”
It works like this:
“If you got $300, your $345 is due on your next pay date,” Williams says. "If you don't come in and buy it back, then we deposit it into your account. If it's non-sufficient, it comes back to me non-sufficient. Then I have to work that check. Like I'll, I call the bank to see if it's available. If it's available, I go pick it up. If not, I have to keep calling you.”
Part of a payday lender’s job is to be a debt collector. Williams says it happened often. But it’s also possible that a payday lender would sell your debt to a separate debt collector.
Apart from being harassed by a debt collector, which could damage your credit rating, the reality is, you can’t borrow again if your account is in default.
Caution: Payday and Short-term Loans Will Not Likely Build Your Credit
One of the myths about payday loans, or, really, any kind of short-term loan, is that they can help build your credit. That’s very unlikely, as most small-dollar, short-term lenders do not report your payments to a credit bureau. You can ask them to, but they are not obligated to do so. However, if your account with a lender goes into delinquency, the lender might sell your debt to a debt buyer, who might report the default to a credit bureau. So the chances of a payday loan building your credit are almost zero, but the chances that a default on a payday loan could damage your credit are substantial enough for you to be concerned about.
More resources about payday loans:
- This primer on payday loans and credit scores from the Consumer Finance Protection Bureau
- This guide to understanding credit scores from South Carolina Public Radio
Title loans (a.k.a., auto title loans)
Like payday loans, title loans often don’t require a credit check in order to get them. Also like payday loans, title loans are lent for a short period of time.
The big difference between a payday loan and a title loan is that a payday loan is an unsecured loan, while a title loan is a secured loan.
Unsecured vs. secured loans: An unsecured loan, also called a signature loan, is a product from a bank, credit union, or other lender that is not backed up by any form of collateral. It typically comes with high interest rate paid up front to protect a lender against default. A secured loan is a loan product on which you leverage an asset — a vehicle, a house — as collateral. These loans tend to be easier to qualify for, but the penalty for defaulting can be badly damaged credit or loss of your asset.
Title loans work like this: You borrow an amount of money (as little as $100 in some shops and as much as $10,000 in others, depending on the value of your vehicle), and you temporarily sign the title to your vehicle over to the lender. The lender gives you a payback period — often no longer than 30 days, according to Appleseed legal Justice Center in Columbia — and if you pay the loan back within that time, you get the title back. If you default, the lender might seize your vehicle and sell it.
Title loans, despite being a form of secure loans, typically carry a high interest rate. According to the Federal Trade Commission, the average interest rate on a title loan is 25 percent. If you have to reborrow that money, which many customers do in order to keep the loan from defaulting, you could see as much as a 300 percent APR on that loan.
Now, yes, short-term borrowing is theoretically designed to be a temporary solution, not something you keep running like a mortgage. This is what workers in the short-term lending industry often balk at — the idea that critics of short-term lending often assume that borrowers keep borrowing and reborrowing the same amount of money over many months or a year.
Ed D’Alessio, the executive director of InFin, the main trade alliance for short-term and small-dollar lenders in the U.S., based in Washington, D.C., says that critics make the argument that “if you're driving along and you see a loan that's offered at $300 and it costs you $15 for every $100 you borrow, that equates to a 360 percent APR."
You're going to look at that and say, wow, that's sky high," he says. "But the 360 percent APR is an inflation of the actual, representation of what the loan costs.”
The main thing to know about installment loans is that most loans, secured or unsecured, are installment loans. An installment loan is simply a loan you pay off in installments, like a mortgage, a title loan, a student loan, a credit card balance. It has a set balance and a defined payoff date.
The longer the payback term, usually the better the interest rate is, and the lower the regular payments. A $100,000 fixed-rate mortgage, for example, will carry an interest near prime and you’ll pay about $800 every month for 30 years.
But a short-term installment loan usually carries much higher interest. There are several kinds of short-term installment loans:
- Title loans
- Buy now, pay later contracts (or rent-to-own contracts), by which you buy a product with a down payment and then pay it off in installments. This can make a product much more expensive than if it’s purchased outright. For example, I once priced a shed for my backyard that was offered for sale at about $3,000 outright. But the place (which has since taken down its pricing and financing page online, not for nothing) offered an instalment plan that, after five years, would have made the cost of that same shed about $7,000. I won’t name the place, but I would recommend you ask how much your ultimate bill will be if you ever buy a shed on time.
- Installment cash advance loans, which could be secured or unsecured. Borrowers often get a card with a limited amount of money — akin to a prepaid credit card — up to which you could spend. This works like a line of credit in that you don’t have to use the full amount of money you qualify for and you only make payments on the money you use. Say you get a card with a $5,000 limit. You might only spend $1,000, and you pay back that $1,000 and the interest on that amount, not the full $5,000. The advantage of these loans is that they typically come with a longer time to pay down than payday and title loans, but they still tend to carry high interest rates. Here’s an example of one lender’s terms on a $600 loan with a three-month payback window. Interest comes to $188.82, which is an interest rate of just over 214 percent.
The bottom line
Short-term, small-dollar loans are intended to be temporary fixes to minor problems, not permanent bills. But while industry proponents stand by that perspective, critics usually say that these loans frequently end up being not temporary at all. SC Appleseed’s “Easy In, Impossible Out” report spells out how easily short-term, small-dollar, high-interest rates can become nagging burdens for vulnerable borrowers who don’t have many better options.
The watchword, as it always is with borrowing (and lending, to be fair), is "caution." All borrowing is risky. If you are able to access more affordable loan products, you should look into them.
Two quick solutions:
- Payday alternative loans, or PALS. PALs are available through credit unions – which you likely qualify to be a member of in your community – and they seek to lend small amounts (usually between $500 and $2,000) with low interest rates and come with a payback period of months or even a year. PALs might also go by names like “Express Loans,” as they do at Founders Federal Credit Union in South Carolina, for example.
- Financial help from a CDFI. Community Development Financial Institutions are all over South Carolina, and they exist to help you figure out whether you even need a loan to help you through your emergency (because you might need something like rental assistance that you could apply for and forego a loan you’ll have trouble paying back). CDFIs usually deal with housing issues, but many offer free or low-cost financial services to their communities. You can find a list of CDFIs in South Carolina here.