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Payday loans risky, even at banks

By Claes Bell, CFA · Bankrate.com
Thursday, March 21, 2013
Posted: 5 pm ET

On the lookout for new sources of revenue, a substantial number of banks have begun offering payday loans to account holders.

But whether it's called a payday loan or a "direct deposit advance," these products can be financially risky for borrowers, even at mainstream banks, according to a new study by the Center for Responsible Lending.

The way the product works is simple. The bank deposits an advance into a borrower's checking account, then automatically withdraws the amount when the funds come due, plus fees. In practice, they can really complicate the financial lives of borrowers.

According to the study, banks charge an average flat fee of $7.50 to $10 per $100 borrowed. When you take into account that the average loan term is 12 days, those fees amount to an annual percentage rate of 225 percent to 300 percent, according to the study. That's actually an improvement over last year's study, when all the banks surveyed charged $10 per $100.

But while the loans are pricey, the toughest thing for borrowers is that the loans come due as a balloon payment, meaning the bank takes the entire principle in one lump sum the next time the borrower gets a direct deposit. That often leaves the borrower strapped for cash again, leading to more borrowing. According to the report, the average payday borrower took out 13 1/2 loans in 2011, with 8 percent of borrowers taking out 36 or more.

Use if these loans also can lead to overdraft fees, as the repayments are taken out of borrowers' accounts automatically.

Put all that together, and you have a recipe for pushing borrowers into a long-lasting financial tailspin that may end in borrowers being reported to a credit bureau such as ChexSystems and being pushed out of the banking system altogether.

Payday loans have long been controversial, and many states have rules about how much interest they can charge and other aspects of their business. It's also possible the federal government may step in at some point to curtail the practice. This year, a group of senators called on banks to stop making payday loans, and the Consumer Financial Protection Bureau said last year it will be taking a close look at the entire payday lending industry.

Whether or not the payday loans should be legal is a more difficult issue than it appears on the surface. Obviously, borrowers should know beforehand that payday loans are extremely expensive and a last resort for emergencies only.

To their credit, some banks make this clear to borrowers. From an FAQ on Wells Fargo's website:

The Direct Deposit Advance service is an expensive form of credit. A cash advance under another form of revolving credit, such as a credit card, is typically less expensive than the Direct Deposit Advance service, if the cash advance is repaid promptly. However, if you have no other credit available to you, and you face an immediate, short-term need for funds, the Direct Deposit Advance service may help you through that situation. We do not recommend regular, repeated use of the Direct Deposit Advance service. If you find yourself in that situation, we encourage you to seek credit counseling (many agencies can be found in your local telephone book) and explore other credit options.

But there will always be people who need access to quick cash to pay medical bills or meet some kind of crucial short-term need, who don't have access to more affordable forms of credit because of a troubled credit history or other factors. If payday loans are outlawed, it's likely at least a portion of those consumers will seek short-term credit at pawnshops or title lenders, which charge similar rates, or from loan sharks who may charge higher rates and do just about anything to ensure borrowers pay up.

What do you think? Should payday loans be outlawed? Should payday lenders have more limits on how they do business?

Follow me on Twitter: @ClaesBell

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