Table of Contents |
When dealing with lenders, you have many choices. Lenders can be generally classified into two different categories, as shown in the following table.
Mainstream Lenders | Alternative Lenders |
---|---|
Banks | Check cashers |
Credit unions | Payday lenders |
Auto manufacturer financing | Title loans |
Credit card issuers | Pawn shops |
Merchant credit cards | Seller-financed used car loans |
The most popular alternative loan is a payday loan, which is a short-term loan designed to be repaid within a few weeks when the borrower receives a paycheck. Here’s how a typical payday loan transaction occurs.
IN CONTEXT
Consider Tisha who works full-time and goes to school. Her car just broke down, which is a real problem because she needs it to get to her job and classes. Her mechanic told her that it would cost $500 to repair it, which is more than she currently has in her savings account. Because Tisha doesn’t have the cash or a credit card to pay for the repair, she panics and visits a payday lender, who agrees to lend Tisha $500.
- The payday lender charges a $75 fee for a two-week loan, but rather than demand the fee today, the payday lender simply adds it to the amount Tisha will owe later. (The APR of this payday loan is 391%! We discuss how to calculate the APR in the next section.)
- As collateral, Tisha writes a check in the amount of $575 and hands it to the payday lender employee.
- When the two weeks are up, Tisha needs to return and “buy back” her check for $575 in cash.
The process is shown in this illustration.
If Tisha doesn’t pay back the loan in two weeks, the lender will attempt to cash the check. If Tisha has insufficient funds in her account, she’ll pay a bank fee and owe the payday lender even more money. Rather than have this happen, Tisha and many payday loan users often roll over one loan into another every few weeks by extending the terms of the original loan. They then get caught in the unfortunate trap of incurring a new fee each time a loan is rolled over.
Problem Solving: Skill Reflect |
To calculate the approximate annual percentage rate (APR) on a payday or alternative loan that is based on fees rather than a stated interest rate, you’ll need to perform a few simple math calculations. In Tisha’s case, she obtained a two-week (14 days) loan for $500 with a $75 loan fee. The illustration below shows how to calculate the APR of this loan.
Take a breath. Yes, that is an APR of 391%! This is the APR if no other fees are charged and assuming Tisha pays off the loan on time.
Pawn shops and title loans work the same way as payday lenders.
Strong problem solving skills allow you to choose the best loan product for your needs. Part of that process is looking at benefits and risks associated with each.
The world of alternative lending is not highly regulated.
Alternative financial service providers seek to provide a high level of social interaction and inclusion for their clients, making customers feel more welcome compared with mainstream institutions. In addition, alternative lenders are quick to point out that fees, such as overdraft charges on checking accounts, late fees on credit card payments, and overdraft expenses on debit and ATM cards, may be higher at a bank than what it costs to borrow a similar amount of money from a payday lender. In general, however, the best approach is to rely on low-cost borrowing options from mainstream financial service providers if possible. Some of these low-cost borrowing options, many of which we’ll discuss in later topics, are shown in the following table.
Table: Borrowing Options and Alternatives
Product | Good Credit Score Required | Additional Application Requirements | Example Finance Charge: $300 for 3 Months* |
---|---|---|---|
Parents or family | No | None. | Likely 0% APR, $0 |
Subsidized student loan | No | FAFSA form. No credit check required. | 5% APR, deferred interest, $0** |
Auto loan at bank | Yes | Must own the car and have equity in it. Complete loan application at bank. | 6% APR, $4.52 |
Personal loan at bank | Yes | Complete loan application at bank. | 10% APR, $7.56 |
Credit card | Yes | Complete a loan application. | 12% APR, $9.09 |
Credit offered by service provider | Yes | Service providers often offer loans to customers to pay for services. The loan is generally made by a national lender partnering with the local business. Complete application at store. | 29.99% APR, $23.06 |
Pawn shop | No | Something of significant value to give to the pawn shop as collateral. If the loan is repaid, the item can be reclaimed; if not, the item is sold. | 200% to 400% APR; $176.39 (at 200% APR) |
Title loan | No | Must own the car without any other loans against the car. No credit check required. | 300% APR, $285.94 |
Payday loan | No | Must write a personal check for the loan amount plus a fee, usually $15 per $100 borrowed. In two weeks, must repay the loan or renew the loan with an additional fee. No credit check required. | 390% APR, $393.92 |
Many Americans fail to set money aside for emergencies. This creates tremendous vulnerabilities for themselves and their families. Ask yourself this: Would you be able to come up with the money if faced with a $2,000 unexpected expense in the next month?
Agility: Skill Tip |
When asked this question in a survey, approximately half of all American consumers said that they could probably not or certainly not be able to come up with $2,000 in an emergency. Although $2,000 is a significant amount of money, it does not require too much imagination to identify possible things that could go wrong to create a bill for this amount. How long would it take to save $2,000 in an emergency fund?
Source: This content has been adapted from Chapter 6.1 of Introduction to Personal Finance: Beginning Your Financial Journey. Copyright © 2019 John Wiley & Sons, Inc. All rights reserved. Used by arrangement with John Wiley & Sons, Inc.
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