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How do payday loans work?

We are bombarded with adverts for payday loans, but are they really such a good idea? Lenders make out its quick and easy to get some extra cash, but a recent investigation has found ‘deep-rooted’ problems with the industry. If you’re thinking of getting a payday loan, here are a few things you should know.

They’re an expensive quick fix – not a long-term solution

Payday loans are traditionally aimed at borrowers who have run out of money towards the end of the month and need some extra cash to tide them over until payday. Many lenders operate online, as well as on high streets.

The loan is usually paid straight into your bank account, often within minutes of applying. The loan repayment, plus interest, is then taken directly from your bank account on the due date.

Expect to be charged about £30 to borrow £100 for up to a month. In other words, if you borrow £100, you’ll repay £130. However, the cost can soon spiral if you are unable to pay the money back on time.

In relation to standard personal loans, the amount you can borrow with a payday loan is relatively low: £50 to £800. However, you’ll need a decent credit score to be able to borrow the maximum.

This all sounds rather straight forward, but campaigners and consumer groups have serious concerns about the way payday lenders operate. Here are some of them:

Of course, if you don’t repay your payday loan on time this will have a much worse effect on your credit score

Loans can be too easy to get

Payday loans are supposed to be one-off, short-term loans that are only used in an emergency. But they are now available 24/7 via mobile phones and the internet, and are heavily advertised, leading many people to use them for impulse and unnecessary purchases.

This easy accessibility of payday loans can become very dangerous because if you’re not careful, you can spiral into a trap of expensive debt that you can’t afford to repay.

Ballooning debts

Payday lenders thrive on making out their loans are easy and transparent. But if you fail to repay a loan on time and ‘roll it over’ for another month, your situation can quickly become a nightmare. As well as the initial interest, you’ll be charged late payment fees and more interest.

Some borrowers are even tempted to get out another payday loan to pay off the first, just to give them some breathing space. But often this cannot be paid either and before you know it, debt collectors are knocking on your front door.

For some people, a payday loan can be a lifeline. However, unfortunately, for many more the first payday loan they take out results in their financial situation worsening, rather than getting better. So think very carefully before you go down this rouse and only go for a payday loan if you really need the money and are confident you’ll definitely be able to afford to pay it back.

We have more information on what happens if you can’t afford to repay your payday loan here.

Lack of flexible repayments

Some payday lenders such as Wonga will allow you to choose the exact amount you want to borrow and the number of days you want to borrow it for. This enables you to reduce the cost of the loan. For example, if you can pay the loan back within 10 days, you’ll pay less than if you borrow the money for a full month.

However, most aren’t so flexible. The majority of lenders have set borrowing terms, usually 28, 30 or 31 days. This means that even if you repay your debt early you’ll still be charged the same amount of interest.

Lenders take money from your account

Payday lenders use something called Continuous Payment Authority (CPA), which means they dip into your bank account to take your repayments. They will try to take a payment on the morning of your agreed repayment date, but if there is no money in the account they will keep on trying. This can leave you without enough money to pay a more important bill such as your mortgage or rent.

If you’re struggling to pay other bills, you can ask your bank to cancel the CPA and instead pay off your payday loan when you can afford it.

Beware that if they can’t get the money from your bank account, lenders will also try and take it from any other accounts you may previously have used to make your payments. This might happen, for example, if a friend or family member has paid off an earlier you’d taken out.

They will also encourage you to borrow more

If you repay your loan on time, expect the lender to tempt you again and again. Your borrowing limit will often be increased, even if you haven’t asked for it, and you’ll probably receive multiple emails or texts encouraging you to borrow more.

Don’t fall for these tactics – it’s just a way for the firm to make more money out of you. It’s really important to try and resist the temptation of regularly using payday loans, even if you can afford to pay them back on time. It’s a really expensive way to borrow and should only ever be a last resort.

It could affect your credit score

Whenever you apply for any type of credit, including payday loans, this is marked on your credit file and used by other lenders in the future to decide whether or not to do business with you.

Even if you repay your payday loan on time, some banks do not like to see applications for payday loans on a credit file. It signals that you have money troubles and this could jeopardise your chance of getting a mortgage, personal loan, or credit card.

A few mortgage lenders, including GE Home Lending and Kensington Mortgages, have explicitly said they will turn down mortgage applicants who have recently taken out a payday loan.

Of course, if you don’t repay your payday loan on time this will have a much worse effect on your credit score, and is likely to seriously damage your chance of getting credit elsewhere.

There are cheaper ways to borrow

Authorised overdrafts are probably the best alternative to payday loans if you need some emergency cash. If you don’t have an overdraft or if you need a higher limit, talk to your bank and see what they can arrange. Even credit cards are a cheaper option, especially if you are organised enough to apply for a 0% interest card.

If you have a bad credit history and have been turned down by main lenders, try approaching your local Credit Union for a loan. See our news article for more information on better ways to borrow

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