Payday Loans

Written by Jeremy Horelick
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Payday loans enjoy widespread use in every state across the country. At the same time, they are one of the most commonly misunderstood forms of credit. The myths surrounding payday loans, when combined with the service's growing popularity among free-thinking, rational consumers, has created a hot-button political topic. But as rife with controversy as the subject is, one thing remains clear: Americans continue to look to payday loans as a dependable source of credit.

The concept of payday loans is simple. Consumers borrow money from payday loan companies, who are either backed by lenders or are direct lenders themselves, and agree to pay back that money with funds from their next paycheck. In financial terms, these individuals are said to "borrow against" their salary or other earnings. The monies owed to the borrower are thus used to "secure" the loan.

A Bit about Loans in General

Loans vary widely in their structures and purposes. Some loans are understood to be short-term provisions intended to tide the borrower over for a matter of days or weeks. Most institutional loans, however, are long-term loans that may be used for anything from the acquisition of companies to the purchase of real estate. The period of time over which these loans are paid back is known as the "term."

As anyone who's ever used a credit card knows, lenders make their money by charging interest over that term. That interest can be calculated and represented in a number of ways, but it's often helpful to think in terms of APR or Annual Percentage Rate. While APR can be a useful yardstick for standardizing loans, it can also be misleading since many loans aren't intended to be calculated annually. When they are, they may well work out to seemingly astronomical rates.

The World of Payday Loans

Payday loans fit the above model perfectly. Lenders charge interest on the money they provide up front and charge a fee, usually a flat percentage of the "principal," for the service. A 100-dollar loan, for example, might cost a borrower 10 dollars in fees (or interest). If that borrower has a full two weeks (the length of the average pay period) to repay that money, and that rate were "annualized," he or she would have a 260% APR. To arrive at this figure, simply multiply the interest payment (10 dollars) by the number of pay periods in a year (26), and divide by the amount of the loan (100 dollars). The result, 2.6, expressed as a percentage of the initial sum, comes out to 260.

Delving into the finer points of finance and comparing different calculation methods is interesting but is only tangentially related to the topic of payday loans. Suffice it to say, there are those who would shed a different light on the above methodology, which is a fair enough criticism. But for most people's purposes, the calculation in the previous example is accurate enough.

The Controversy Surrounding Payday Loans

Call them what you will--emergency cash loans, bad credit cash loans, deferred deposit--but payday loans have incited heated debate throughout the lending industry. This is largely because payday lenders are able to beat the interest rates charged by institutional lenders such as banks and mortgage companies. To fight for their livelihood, these institutions turn where any powerful group would turn for advocacy: government reps and lobbyists.

In the past, payday loans have been debated not only in city and state legislatures, but in courts both regional and federal. Clearly, there's a large sum of money at stake in the lending business, and those who stand to profit the most aren't about to willingly abdicate their power. For this reason, it's expedient for many powerful people to propagate misconceptions about payday loans in order to paint them in a less desirable light. And to a large extent, this smear campaign has worked--at least on those reluctant to explore the facts for themselves.

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