As new Which? Money research unveils a catalogue of poor practice by some payday loan companies, we explain how these loans work and help you find alternative ways to borrow.
What are payday loans and how do they work?
A payday loan is a short-term advance designed to tide you over financially until payday. Some providers, such as Wonga.com, allow you to choose the repayment period, rather than basing it on when you receive your salary.
The loan is usually paid straight into your bank account, often within 24 hours of your application being approved. The repayment, plus interest, is then taken directly from your bank account on the due date. The typical charge is about £25 per month for every £100 borrowed. Advertised interest rates (APRs) can reach 2,000% or more.
Why are the interest rates so high?
Payday loans are, by their nature, expensive. The short timescales, small amounts, credit-checking costs and the higher risk of default by borrowers combine to push up the cost. Some payday lenders argue that APRs are misleading, as the loans are not designed to be long term. They also claim that, even if you do roll your loan over for an extra month, you’ll have to repay the previous month’s interest first, so you won’t have to pay interest on interest (known as compounding). Official APR calculations assume that interest is compounded.
However, when we investigated payday loan companies, our research found that it would be easy to build up increasing amounts of debt over a longer period, simply by alternating between two payday lenders, using one to pay off the other and increasing the amount you borrow each month. Pre-approved extension periods (known as deferrals or rollovers) and increasing loan amounts on offer make this a tempting option that could leave you in unmanageable debt.
Are logbook loans the same as payday loans?
So-called ‘logbook loans’ are even riskier than payday loans. The loan is secured against your car, so if you fail to make repayments you could lose your vehicle, as well as having to pay the high interest charges. As there are often no credit checks, customers who are struggling with other debt could be tempted by these loans, putting their vehicle, and their finances, at risk.
What are doorstep lenders and how do they work?
These work in much the same way as online payday loans, except that repayments are typically spread over a longer period (up to a year) and a representative from the company comes to your house to collect a weekly repayment.
APRs tend to be lower than for payday loans, but are still very high. For example, a £300 loan from Provident Personal Credit (often known as ‘the provy’) will cost you £10.50 a week for 52 weeks. That’s an extra £246 in interest, an APR of 272%.
What are the alternatives to payday loans?
If you’re desperate for cash, payday loans may seem like the best choice. But there are alternatives. For example, current account authorised overdrafts are usually much cheaper than payday loans for short-term borrowing. However, unauthorised overdrafts are generally more expensive, so avoid them.
Another alternative is to join your local credit union. Credit union loans can take longer to arrange, but are limited by law to an APR of 26.8%.
The government’s Social Fund can also provide crisis loans for emergencies and budgeting loans for those on benefits. To find out if you qualify, contact Jobcentre Plus on 0800 032 7952.
Even credit cards aimed at people with a poor credit history can offer a better deal than payday loans. With a high APR of about 40%, you’ll still pay less interest with this sort of credit card, but only if you’re disciplined and pay it off over a short period. If you only make minimum repayments, miss a payment or go over your limit, you’ll not only damage your credit rating, but you could also face penalty charges and your debt can spiral out of control.
- Complain about a payday loan company– our step-by-step guide
- Payday loans – designed to trap you in a cycle of debt? – have your say with Which? Conversation
- How to deal with debt – the best places to get free, impartial debt advice