By Jenna Lee
People in financial trouble may take on payday, pawn shop and car title loans loans to tide them over until they're financially stable. But these seemingly innocent loans often cause them to end up in worse shape than when they started.
On the outside, they just look like convenient ways for people with subprime credit to borrow money. However, there's no such thing as easy money. Read on to learn the truth about these three risky loans, and find some alternatives you should consider instead.
How they work: The payday loan process usually begins with you writing a post-dated check for the loan amount plus interest and fees. When the loan is due, the lender collects the balance unless you choose to roll the loan over (in exchange for more fees, of course).
Why they're dangerous: These loans boast notoriously high interest rates that make it almost impossible for borrowers to pay off their balance on time. Even if they pay a small amount each payday, this often just covers the interest and fees, leaving the balance intact. Richard Cordray, the Consumer Financial Protection Bureau director, said in a statement last year that payday loans are long-term, expensive debt burdens: "For too many consumers, payday and deposit advance loans are debt traps that cause them to be living their lives off money borrowed at huge interest rates." It should come as no surprise that payday loan borrowers often find themselves needing to roll over or take on new loans, trapped in a vicious cycle of debt.
Pawn Shop Loans
How they work: Pawn shop loans typically involve you giving the pawn shop an item that you own (like a television, piece of jewelry or computer) as collateral, and the pawn shop lends you a percentage of the item's value.
Why they're dangerous: These loans are short-term and typically have very high interest rates and a variety of fees. If at the end of the loan period you can't afford to pay the balance plus interest and fees, the pawn shop may keep your item and sell it.
Car Title Loans
How they work: Like pawn shop loans, car title loans use one of your possessions (in this case, your automobile) as collateral to secure a short-term loan for a fraction of what your car is worth –- provided that you own the car free and clear. Just sign over the title of your car, and hand over a set of keys.
Why they're dangerous: As with payday and pawn shop loans, these secured loans typically come with very high (often triple-digit) interest rates and loads of hidden costs, from storage fees to repossession fees. This brings up another huge red flag – if you miss just one payment, fail to pay the fees or aren't able to pay the interest accrued on the loan by the end of the term, your car could be sold or repossessed. Also, since title loans are often only 30 days long, borrowers only have a short amount of time to pay the principal, interest and fees. Since they usually aren't able to pay everything back when it's due, they often renew the loan and the nightmare begins all over again.
How Do These Loans Affect My Finances?
The most redeeming qualities about secured loans are that lenders typically won't check your credit, and the loans aren't reported to the credit bureaus. But while you're frantically trying to gather enough money to pay off those loans, you may neglect paying off things that do affect your credit. So while they may not directly affect your score, know that secured loans can still cause trouble for your credit health.
Even if you're strapped for cash, you don't need to agree to ridiculously high interest rates. Instead of taking on risky loans, consider these other options:
- Short-term loans: Small banks or credit unions may offer you loans with better rates and repayment terms.
- Asking for an extension: If you call your creditors before you miss a payment, they may be willing to give you a due-date extension or work out a payment plan.
- Borrowing from loved ones: It may be uncomfortable, but asking friends or family for a loan could still be a better alternative than secured loans. Just be sure to pay them back -– you don't want to burn bridges.
- Payday advances: If you have a benevolent employer, try asking for a payday advance. Since it's your money, not a loan, you'll save money on interest.
- Emergency assistance programs: You may find emergency assistance from community organizations or social services programs. In many areas, a call to 211 will connect you to help.
- Cash advances on credit cards: While not ideal, the 25 to 30 percent in interest you may be charged for a cash advance is certainly better than triple-digit interest via the loans covered earlier.
Personal finance experts always recommend building up an emergency fund so you can avoid dangerous situations that are hard to escape. If you're not desperate for money yet, don't wait until an emergency strikes. Avoid living paycheck to paycheck at all costs, even if you have to trim your spending and live less comfortably.
It may seem hopeless, but you can get through this tough time without taking on a secured loan. Just remember: Evaluate your options, know what you're getting yourself into and breathe.
Jenna Lee is the social media manager for CreditKarma.com, a free credit monitoring website.