The Smart About Money website will be retiring on July 31, 2021. Learn more about this decision.


Protect Yourself Against Loan Scams

neon payday loan sign

Predatory lending takes many forms including car title loans, tax refunds and payday loans. The interest rates on such loans are astronomical and victims quickly can fall into a debt trap.

Ann, a client at Utah-based Community Action Services and Food Bank whose name has been changed to protect her identity, was a single mother with two boys when she began taking out payday loans to cover her basic bills.

Tisah Ockey, a coach at Community Action, says Ann had everything going well at first. She had a full-time job doing medical coding at a hospital and she received health benefits for herself and her family. But when Ann developed health problems and her doctor told her she could not sit at a desk for eight hours a day, she had to leave that job.

Unemployed with two sons and health problems, and living in a shelter, Ann began taking out payday loans to pay for her basic expenses.

"Ann had no one to turn to, so she went to the lenders,” says Ockey. “She had to pay her bills somehow."

Payday Loans: A Slippery Slope

Ann began with one payday loan, but soon had to take out a second loan to pay off the first. With the high interest rates of these loans, Ann’s debt quickly spiraled out of control — at one point, she maxed out six active loans.

When Ann would go in to pay the bill for one loan, the lender would try to push her to take out another loan, compounding her stress.

Shay Farley, a lawyer for the nonprofit legal advocacy organization Alabama Appleseed, says payday loans carry interest as high as 456 percent and fees of $50 or more. Interest rates are high due to the loan terms, which usually require payback within as little as two weeks.

The average payday borrower, Farley says, pays 37 percent of his or her income to the lender, which takes away from other bills.

"Nobody is helped by a loan that takes up a third of their paycheck," says Farley. "Typically the borrower doesn't have the money to pay back the loan."

The Payday Loan Hook

Payday lenders do not check a borrowers’ credit or their ability to repay. Supporters of payday lending argue this is a good thing because it serves a specific audience that has limited access to traditional credit. However, Farley argues that lenders could look at income, instead of credit score, to determine if a borrower is able to afford to repay a loan.

Predatory lending doesn't just affect the individual borrower — there also are moral and economic aspects. Farley says that for every $1 in interest paid to payday lenders, $2 is eroded in consumer spending and ability to pay other bills.

For example, one of Ockey’s clients took out an $800 payday loan to pay rent and then used his tax return to pay off the loan within the 30-day time frame. With interest, the client owed $1,200. Ockey says the lack of consumer education from lenders is a big problem.

"The payday lenders are great at taking advantage," says Ockey.

"Families in crisis look at [payday lending] as an option,” says Myla Dutton, Community Action's executive director. “It's much harder and more costly in the long run. It becomes a trap."

As a personal experiment with payday loans, Dutton herself took out a $500 loan from a payday lender. She paid off her loan, but learned that lenders do a poor job of educating borrowers.

Dutton says that Community Action agencies offer an alternative to payday loans by providing help with food, housing, energy assistance, education and asset building. By getting help from such an agency, a family may be able to avoid taking out a payday loan to cover bills.

What Can Be Done About Predatory Lending?

Farley says legislative action needs to be taken to get rid of payday lending. Fringe loans such as these didn't exist until the '90s, she says, and the government has been slow to regulate them.

Some municipalities restrict how close payday lenders can be to each other, but each state is different. Alabama is dense in predatory lending, as is much of the South. On the federal level, Senator Dick Durbin (D-Il) has introduced legislation limiting the interest rate for loans to 36 percent.

In 2006, the Department of Defense requested Congress pass legislation limiting the interest rate charged to active duty military members to 36 percent, as well. The department’s report found predatory lending, such as payday loans, rent-to-own offers and car title loans, weakened the military because it decreased service members’ morale and put their security clearances at risk. Farley says similar legislation needs to be passed so all consumers are protected.

Ann, the Community Action client, was lucky. She received $12,000 in back child support, which she used to pay off all of her debt, including the payday loans and a car loan. Ann told Ockey she wishes she had never gone to a payday lender, because she could have used the child support as an asset for herself and her children rather than to pay off debt.

If you believe you have been the victim of predatory lending, contact your state attorney general to file a complaint, or find a credit counselor.

[Any reference to a specific company, commercial product, process or service does not constitute or imply an endorsement or recommendation by the National Endowment for Financial Education.]