The High Cost of Informal Short-Term Credit

Contrasting the Alternatives to Payday Loans

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Table of Contents
Introduction and Summary..........................................................................................................3 The High Cost of Payday Loan Alternatives...............................................................................4 Short-Term Credit Options are Becoming More Limited...........................................................6 Payday Loans May Actually Help Consumers...........................................................................6 Conclusion.....................................................................................................................................9 Glossary.........................................................................................................................................10 References....................................................................................................................................11

Introduction and Summary

Living paycheck-to-paycheck is never an ideal situation, but for 71.6 percent of Americans (American Payroll Association, 2010), it is a stark reality. After covering typical living expenditures, like rent, utilities and groceries, many consumers have very little left over for emergencies. When disaster strikes, whether it is a medical emergency or an urgent need for auto repairs, they seek out short-term credit options to cover these expenses. Some choose to use credit cards, overdraw their checking accounts, or forgo paying their bills. Others choose payday loans, which may help preserve their credit ratings while supplying the short-term credit they need to smooth over temporary gaps in income. Payday loans, also known as cash advances or payday advances, cover small, unexpected expenses that crop up in the course of everyday life. Whether it is a doctors visit that health insurance will not cover, an auto repair that cannot be put off because the consumer needs to be able to get to work, or an unexpectedly high heating bill, payday loans provide a way of meeting unexpected expenses. If eligible and for a fee, consumers can obtain traditional payday loans or online payday loans. Many lenders also offer extended payment plans if the consumer cannot afford to pay back the loan on its due date. Additionally, 100 percent of all payday loan users have steady incomes and checking accounts. They are not the fringe below the poverty line but are average lower- to middle-class working Joes trying to provide for their families (Community Financial Services Association of America, n.d.).

Contrary to popular belief, the average payday loan

Earn between $25,000 and $50,000 per year Have a high school diploma or better (90 percent)

user is not poverty-stricken. The majority of payday loan users:

In fact, most payday loan users are the heads of young families 63 percent of payday loan users have children in the household, and 53 percent are under 45. Typically, they dont have access to traditional credit lines due to poor credit scores. As underbanked consumers, they typically

Have attended college or have a college degree (54 percent) Have major credit cards (54 percent)
(Community Financial Services Association of America, n.d.)

do not have savings or disposable income available for use when an emergency expense occurs (Community Financial Services Association of America, n.d.). Payday loan users are not frivolous. The majority of them save whatever is left from their paychecks at the end of the month after expenses (33.4 percent) or deliberately and regularly set aside money for savings (29 percent) (Elliehausen, 2009). They have jobs and checking accounts in fact, these are requirements to borrow a payday loan. For whatever reason, they dont have the cash they need to cover something unexpect2 3

ed, may have been turned down for credit, and need a fast, short-term loan. Unexpected expenses that need to be paid immediately affect 70.8 percent of payday loan customers (Elliehausen, 2009). Unfortunately, the options available to consumers stuck in a bind by surprise expenses arent very attractive. Some of these options include payday loans, late fees, reconnect fees for utilities, overdraft fees, and returned check fees. All of these can damage the consumers credit rating in some way, but if used correctly, payday loans may be a better alternative to bridge the gap to payday when an unexpected expense arises.

The average household saw a 10 percent increase in NSF fees, from $343 in 2008 to $376 in 2009 (Bretton Woods, Inc., 2010). Active households, which are one of 20.2 million households writing 1.03 billion NSF checks, face even steeper fees. Each of these households pay an average of $1,472 in NSF fees per year. (Bretton Woods, Inc., 2010). Bretton Woods, Inc., a management advisory firm specializing in financial institutions, does not see the cost of NSF fees decreasing. Based on its research and year-over-year observations, it only predicts an increase. Whether a payday loan is borrowed in an emergency or non-traditional credit options are used, both can be fast and cover expenses in a pinch. However, there are hidden costs associated with not paying bills on time, and not all of the costs can be measured in dollars and cents. In addition to fees, using these short-term credit options also may mean:
A lower credit rating if bills are left unpaid Time spent without phone service, gas, or power if bills are left upaid The possibility of auto repossession meaning a loss of transportation to work if car payments arent met The possibility of eviction if rent is not paid Possible criminal charges for bouncing checks

The High Cost of Payday Loan Alternatives

Informal short-term credit alternatives end up helping many Americans bridge the gap between paychecks, particularly when they need to cover an expense right away. Not everyone can qualify for traditional bank loans, but they may still be faced with emergency expenses, so many are forced to pay: Credit card late fees Credit card over-the-limit fees Checking account overdraft fees Late fees on loans, such as auto loans Returned check/bounced check/nonsufficient fund (NSF) fees Late fees or reconnection fees on utilities, such as phone, gas and electric Bank service fees have risen dramatically in recent years, almost doubling from $16.4 billion in 1995 to $32.6 billion in 2003. From that, banks collected $22 billion just in overdraft fees. Credit card companies collected over $11 billion in late fees in 2005. Businesses collected $57 billion in late payment fees (Lehman, n.d.). As shown in the chart below, the fees for using non-traditional forms of short-term credit can be steep:
1 2

Typically when a person is at least 30 days late with a payment, it shows up on their credit report (Yochim, n.d.). Therefore, delaying payments because of unexpected expenses may be harmful to their financial future. Here is an example of what can happen: A person needs unexpected car repairs so that they can get to work, so they use the money they have set aside for their electric bill to pay for the car repairs. The electric bill is not

Fees for Non-Traditional Forms of Short-Term Credit

Credit card late fee Credit card over-the-limit fee Credit card interest rate (after default) Returned check/bounced check/NSF fees Utility late fees Water reconnection fee Utility reconnection fees

paid on time. If the person is more than 30 days late paying the electric bill, the electric company can report this to the credit bureaus, which could negatively affect the persons credit. Utility companies may also charge a deposit for reconnection if service is repeatedly disconnected (Bankrate.com, 2011). Another example of a negative affect of using non-traditional short-term credit options is not making mini-

$25/$351 $351
29.99% and up
2

mum credit card payments. Contrary to popular belief, some credit card companies may raise interest rates on the entire balance for one late payment (Bankrate.com, 2011). Late payments on bills can additionally drive up ones interest rates (Bankrate.com, 2005). Even if a credit card holder defaults on an electric bill and not their credit card, the credit card company can still pull their credit report and raise their interest rates, since the credit card holder is a credit risk (Bankrate.com, 2011). Finally, while over the limit fees have mostly disappeared (Consumer Financial Protection Bureau, 2011), some credit card issuers still charge fees ranging from $15 to $35 for going over the credit cards limit (Bankrate.com, 2011). A third example of a non-traditional short-term credit option is overdraft frees. Overdraft fees in particular can be very expensive. Many banks may charge overdraft fees every time an account is overdrawn. The bank may assess an overdraft fee, which is typically $31 (Bankrate.com, 2011) on every purchase throughout the course of a day of separate purchases including a $1 cup of coffee, a $5 lunch and a few miscellaneous items at the grocery store could cost an extra $75 or more. 4 5

$29.582 $253 $504 $28.505

$25 for the first violation; $35 for each subsequent violation (Bankrate.com, 2011) Average fee as of 2009 (Bretton Woods, Inc., 2010) 3 Late fees can be a percentage of the overdue amount or a flat fee (Sanders, 2011) 4 (City of Centerville, 2011) 5 (City of Tallahassee, 2011)

Many banks may charge overdraft fees every time an account is overdrawn.

Quite simply, the alternatives to payday loans outlined above may result in consumers paying high fees and higher interest rates, as well as damaging their credit. This is why payday loans could be a better option for consumers. Fees are capped, and there are no hidden interest rate hikes, as with credit cards.

Payday Loan Fees by State per $100 Borrowed

(unless otherwise indicated)
Florida South Dakota Washington California Louisiana Maine $25 $15 ($10 per every additional $100 borrowed after $500) $17.65 (or $45 total, whichever is less) $20 (or $45 total, whichever is less) $15 for $100 - $200 borrowed, $25 for $250 - $300 borrowed
(CashNetUSA, 2012)

$10, plus $5 flat fee

Short-Term Credit Options Are Becoming More Limited

As new regulations are passed, consumers are finding their options for short-term credit limited. On July 1, 2010 regulations passed requiring banks to stop charging overdraft fees on ATM transactions or one-time debit card transactions without the customers approval (U.S. Federal Reserve, 2009). However, these regulations also limit the number of transfers that can be made each month, including using a savings account to cover overdraft fees (University Federal Credit Union, n.d.). In response to the Great Recession of 2008 and stagnant economy, many lenders have reduced the lines of credit they grant. Credit card companies have also proactively cut their customers credit limits. The economy also has resulted in less credit availability, particularly to low-income consumers and consumers with lessthan-perfect credit ratings (Prater, 2010). That leaves some consumers twisting in the wind when they need extra money, particularly for unexpected expenses. The Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009 resulted in a decrease in penalty fees and an increase in credit that is available to consumers. However, it also meant that companies that charge penalty rates increased the amount they charged. The average penalty rate is now 29.9 percent, up from 21.9 percent before CARD was passed (Investopedia, 2011).

In situations where a consumer is faced with an emergency expense that needs to be covered before their next payday, the fee for a payday loan is lower than the fees for other short-term credit options like incurring late bill payment fees. Upfront fees for a payday loan are for each $100 borrowed. However, even if the consumer borrows more than $100, the flat fee paid may be more attractive than losing heat or electricity for a few days, or seeing her credit card interest rate raised due to a late payment. Most people are not borrowing a large amount when they turn to short-term credit options. The majority of payday loans are less than $300, at 64 percent of all loans granted (Elliehausen, 2009). Furthermore, many states limit the amount that can be borrowed. For someone borrowing a quick $100 to cover an emergency expense between paydays, payday loan fees are less than the alternatives.

Average Non-Traditional Short-Term Credit Options Across America

Type of Fee
Overdraft protection Credit card late fee Bounced check/NSF plus merchant fee Payday loan
(Bankrate.com, 2007), $25 for the first violation $35 for each subsequent violation (Bankrate.com, 2011) Average fee as of 2009 (Bretton Woods, Inc., 2010) 9 (Consumer Federation of America, 2011)
6 7 8

Average Fee $296 $377 $568 $259

Payday Loans May Actually Help Consumers

As outlined above, payday loans may be a better choice for consumers that need short-term credit to cover an emergency expense. Just in terms of money alone, most fees for payday loans are nominal compared to late fees, bounced check fees or reconnection fees. After looking at the above charts detailing these fees, compare them to the chart on the following page.

While it is hard to gauge how many customers overdraw their checking accounts versus how many choose payday loans, overdraft fees can take a chunk out of someones paycheck much faster than the flat, one-time fee charged by a payday loan lender. Consider what the five largest banks charge in overdraft fees. These five banks account for 32 percent of deposits in the United States. The numbers are impressive, but so are the intangible benefits of payday loans when used in an emergency situation. One of the biggest benefits of payday loans is that they help people avoid bank overdraft charges or utility company late fees, which, if incurred, can negatively impact the persons credit score. Here are details on how payday loans can positively affect a customers credit score: Some payday lenders do not report to traditional credit bureaus. If the customer defaults on his payday loan, the lender typically will not report the default, and the customer dodges a potential black mark on his traditional credit report (Edminston, 2011). Be aware, however, that some pay day lenders do report to CoreLogic, which is launching an expanded credit score in partnership with FICO in 2012 (Skowronski, 2011). Payday loans do not appear on credit reports. Credit is affected, in part, by the number of out standing loans and late payments that a person has. However, a payday loan does not appear on a persons credit report, reducing the amount of loans in the eyes of credit bureaus (Edminston, 2011). Payday loans free up credit. When a person chooses a payday loan, they are not charging the amount to their credit card. That means a lower debt-to-credit limit ratio, which has a positive impact on their credit score (Edminston, 2011). In a study done by Gregory Elliehausen at Washington State University, nearly half of 1,173 customers had considered alternatives, like credit cards, but ultimately settled on payday loans. Over 80 percent of them did not have enough money in their bank accounts, so they chose a payday loan to avoid overdraft fees (DeYoung, 2009).

Bank Overdraft Fee Comparison

Initial Overdraft Fee Bank of America Wells Fargo JP Morgan Chase Citibank US Bank
(BankofAmerica.com, 2012) 11 (WellsFargo.com, 2012) 12 (Chase.com, 2012) 13 (Citibank.com, 2012) 14 (USBank.com, 2012)
10

$3510 $3511 $3412 $3413 $15 per overdraft $15 or less14 $35 per overdraft $15.01 or more

Consider an example of a consumer in South Dakota with several unexpected small cash needs at the end of the month. A new car fan belt, at $85, is needed in order to get to work. A medical prescription is needed that costs $115. In addition, due to rising oil prices and colder weather, the consumer needs to refill their homes heating oil tank sooner, or risk paying $100 plus the cost of oil to fix the boiler if the system shuts off. A total of $300 is needed at this point. These expenses could be charged to a credit card, but the card is maxed out, and the consumer could potentially incur over-the-limit fees on each transaction. At an average fee of $35 per transaction, $105 would be spent. This does not include what the interest rate would be after going over the credit card limit. The consumer does not have enough money in their checking account, so a $29.58 charge per overdraft would be incurred, at a total of $88.74. That is assuming the consumer does not have overdraft protection. Alternatively, the consumer could get a payday loan, which would cost $25 per $100 borrowed for a total of $75 in fees. By using a payday loan, the consumer would save $30 on credit card over-the-limit fees and almost $14 on overdraft fees. Based on the benefits to the customer, choosing a payday loan over other short-term credit options is a prudent choice for consumers in a pinch. In situations similar to those outlined in this report, payday loans can offer lower fees than other short-term credit options. In these situations, payday loans are a viable option for consumers with unexpected expenses that need money quickly to pay for something as urgent as car repairs or medical care.

Conclusion

Short-Term Credit Costs for $300 in South Dakota

Cost per Transaction Credit card over-the-limit fee Checking overdraft fee Payday loan
15 16

Total Cost $105

$35

15

$29.58 N/A

16

$88.74 $75
17

(Bankrate.com, 2011) Average fee as of 2009 (Bretton Woods, Inc., 2010) 17 (CashNetUSA, 2012)

Glossary
Annual percentage rate (APR) the cost of credit that consumers pay, expressed as an annual percentage. Also known as an interest rate. Credit bureau an agency that gathers information about the credit history of consumers, then provides that history to credit grantors, such as banks, for a fee. Credit card a plastic card issued by a bank that allows consumers to make purchases and pay for them later. Purchases not paid for within 30 days are subject to an APR. Credit Card Accountability, Responsibility, and Disclosure (CARD) Act of 2009 a law passed in 2009 that went into effect on February 22, 2010. Among other provisions, it reduced over-the-limit and late fees and curbed interest rates on credit cards. Eviction the process of removing tenants from their rental property. Federal Reserve system established by the Federal Reserve Act of 1913 to regulate U.S. banks. Late fee the fee charged by a credit grantor, such as a credit card company or utility company, when the borrower does not pay on time. Merchant fee the fee charged by a merchant to a consumer for a returned/NSF/bounced check. Nonsufficient funds (NSF) the term used when a check cannot be honored because there are not enough funds in the bank account. Also known as a returned check or a bounced check. Overdraft credit granted by a bank to honor checks in the case of NSF. Payday loan a small, short-term loan that is repaid on the borrowers next payday. These loans are meant to cover unexpected expenses. Reconnect fee the fee that utility companies charge to reconnect services such as electricity and gas. Repossession the act of a financial institution taking back property that it financed. For example, repossession on a car would occur if the borrower failed to make timely payment on the car loan.

References
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