Why Are Payday Loans Bad: The Risks & Alternatives to Predatory Loans

Have you ever found yourself in a situation where you needed money immediately? Maybe your car broke down, or you had an unexpected bill. During times like these, payday loans might look like an easy solution. But they come with a big catch.

In Canada, more and more people are turning to payday loans as a solution to their financial emergencies. This trend is growing because it’s easy to get these loans—often, all you need is proof of income and a bank account. Many Canadians might need this money for emergencies or when things get tough before their next paycheck comes in.

But there’s a big downside: these loans are often very expensive because of high-interest rates and fees. This can make it hard for people to repay the loan and lead to more debt problems. Even though these loans can be handy because they’re fast and don’t require a credit check, they’re not the best choice for everyone.

In this blog, we will talk about why it’s best to avoid payday loans. We’ll explain how they work in simple terms, why they cost so much, and how they can make it harder for you to manage your money in the long run. By the end of this guide, you’ll understand the real cost of payday loans and why it’s important to think twice before getting one.

What is a payday loan?

Payday loans are like a quick fix when you need money fast. Imagine you’re running low on cash, and your next paycheck isn’t coming for a while. A payday loan is an unsecured short-term personal loan that gives you a cash advance on your next paycheque immediately, which you’re supposed to pay back as soon as you get paid or by the loan due date. It sounds helpful, right? But there’s a catch.

These unsecured personal loans are really easy to get, which is why so many people jump at the chance without thinking twice. However, payday loans come with very high-interest rates. This means when it’s time to repay the loan, you owe a lot more money than you borrowed. Plus, if you can’t pay it back on time, you could end up in a tricky situation where you owe even more.

How do payday loans work?

To get a payday loan, you usually need to provide personal information like your identification, proof of income, and sometimes a bank account number. The process can be quick. There are even options to apply for online payday loans. The amount you can borrow is often small, usually between $100 and $1,500, and is intended to cover short-term needs. The exact amount might depend on your income and the lender’s policies.

The payday lender will then have you sign a contract. Make sure you read the contract carefully before you sign it. In the contract, it will list:

• How much you’re borrowing.

• The fees.

• The payment schedule.

• When the loan is due.

The lender will give you the cash or transfer the money to your bank account. This can happen very quickly, often within a day. In some cases, you may receive a pre-paid card or cash card.

You then typically have 14 days from the date of deposit to repay the loan amount. Keep in mind that it is illegal in all provinces for payday lenders to make you sign a form that transfers your paycheque directly to them.

The high costs of payday loans

Payday loans might seem like a quick help when you need money, but they come with a big downside: they’re very expensive. Payday loan interest rates are very high compared to other types of loans. The interest is often charged as a flat fee for the amount borrowed, and it can be quite high when calculated as an annual percentage rate (APR).

When you borrow money through a payday loan, the company charges you interest. Think of the interest as a fee you pay for borrowing money, and for payday loans, this fee is exceptionally high compared to other types of loans. The problem is that payday loan interest rates in Canada typically range from 300-500% APR.

For every $100 you borrow with a payday loan in Canada, they typically charge you a fee of around $15. Imagine you borrow $100, and they ask you to pay an extra $15 just for borrowing it for a couple of weeks. That’s a lot more than what banks or credit cards charge.

In fact, when you do the math, that equals out to almost a 400% APR. For comparison, according to Forbes, the average personal loan rate through banks and credit unions for Canadians with fair credit in April 2024 was 14.20% APR.

Now, you may be thinking that $15 doesn’t sound like much to pay back if you can get $100 quickly. But imagine if you had to borrow $1,000. You now have to pay an extra $150 when you pay back that loan. If you’re already tight on money, coming up with an extra $150 can be very difficult.

Moreover, on top of the high interest, there are also fees if you can’t pay back the loan on time. This means you could end up owing much more money than you first borrowed. For example, if you can’t pay back that $100 on time, you might have to pay extra fees, making it even harder to catch up.

How much can payday loan lenders legally charge in Canada?

You should only think about getting a payday loan if you really have no other choice. This might be when you have bad credit, owe a lot of money, or don’t have any savings. Even though payday loans are often advertised as being cheap and easy, they’re actually not.

Many provinces regulate how much a payday lender can charge for fees and extra costs. Here’s how it varies by province:

Alberta, British Columbia, New Brunswick, Ontario, and P.E.I: the max amount per $100 is $15 or 391.07% APR.

Manitoba, Nova Scotia, and Saskatchewan: the max amount per $100 is $17 or 443.21% APR.

Newfoundland & Labrador: the max amount per $100 is $14 or 365% APR.

What happens if you can’t pay back a payday loan on time?

If you miss your loan payments, you’re going to run into some trouble, and exactly what kind of trouble depends on where you live since different provinces have their own rules. But generally, here’s what might happen:

First off, the payday loan company might hit you with a fee because there wasn’t enough cash in your account to cover the payment. Then, your bank or credit union might also charge you because your account was short on funds.

On top of that, the payday loan lender could start charging you interest on the amount you haven’t paid back yet. This means the amount you owe just keeps getting bigger because of all these extra charges and interest.

If things get really serious, the payday loan company might hand your debt over to a collection agency, and that’s going to show up on your credit report, which will affect your credit score negatively. They might even decide to take you to court over the debt.

Basically, if you don’t pay back your payday loan on time, you could end up in a real mess. It’s like falling into a hole that just gets deeper and more difficult to climb out of. This is known as a payday loan debt cycle.

What is a payday loan debt cycle?

A payday loan cycle is when you keep borrowing more payday loans to pay off the ones you already have. It starts when you take out a payday loan because you need quick cash. But because these loans have high fees and need to be paid back quickly, you might find it hard to pay them off on time.

When the due date comes, and you can’t pay back the loan, you might take out another payday loan to cover the first one. This can lead to a pattern where, for every payday, you need to borrow more to keep up with the loan payments instead of having money for yourself. This cycle can be challenging to break and can lead to owing a lot more money than you originally borrowed.

How do payday loans affect your credit score?

When you get a payday loan, and you’re late paying it back, or if you can’t pay it back at all, it can really hurt your credit score. Your credit score is what financial institutions and other companies use to decide how likely you are to pay back the money you borrow. A good credit score means you’re a safe bet, while a bad one can make it hard for you to borrow money in the future.

The fees and interest from payday loans can add up quickly, making it harder to pay off the loan. As your debt grows, it can hurt your credit score because it looks like you’re struggling to manage your money.

Having a low credit score can make it tough to get a loan for things you might need in the future, like a car or a house. It can even affect your chances of renting a home or getting certain jobs.

If you don’t pay your payday loan on time, the lender might report you to the credit bureaus. Once it’s on your credit report, it can lower your credit score. And if you don’t pay back the loan, the payday lender might give your debt to a collection agency. Then, the agency might also report your unpaid loan to the credit bureaus, which can further drop your score.

Finally, if a payday lender or a collection agency decides to take you to court over the unpaid loan and they win, this could end up on your credit report, too. Legal actions like these are also bad news for your credit score. If you reach this point, you’ll likely see a significant drop in your credit score.

What can you do to avoid payday loans?

If you’re in a tight spot and need money right away but want to steer clear of payday loans and their high costs, there are several strategies you can try. Each option has its own benefits and might work best depending on your situation. Here are some alternatives to payday loans:

Ask for an advance at work

Some employers might let you get some of your paycheck early if you’re in a bind. It doesn’t hurt to ask, and it’s interest-free money.

Get overdraft protection

Some bank accounts offer overdraft protection, which lets you spend a little more than you have in your account. There are fees, but they might be less than those of a payday loan. Make sure to check the details first.

Use a credit card

If you have a credit card, it might be cheaper to use it than to take out a payday loan. Try to pay off what you owe before interest adds up. You may even consider a cash advance on your credit card to pay off your loan. While the annual interest rates on credit cards are also very high, they are peanuts compared to a payday loan.

Apply for a personal loan from your bank

If you have decent credit, you might qualify for a personal loan from a bank. These will have lower interest rates than payday loans. The application process might take a bit longer, but it can save you money in the end.

Or credit union

Again, credit score permitting, consider opening a line of credit or personal loan with your local credit union. Credit unions are like banks, but they often have lower fees and interest rates. If you’re a member of one, you might be able to get a small loan with better terms than a payday loan.

Talk to your creditors

If you’re trying to borrow money to pay off bills, it might be worth talking directly to your creditors. Many are willing to work out a payment plan or even offer you a grace period. This approach can help you avoid taking on more debt to pay off existing bills.

Ask your family or friends for help

Asking for help can be hard, but sometimes, the quickest and easiest way to get some cash is to ask family or friends who understand your situation. It’s important to treat this seriously, though. Agree on when you’ll pay them back to keep things smooth.

I’m already caught in a payday loan debt cycle; what can I do?

Getting caught in a payday loan cycle can feel like being stuck in quicksand—the harder you try to get out, the deeper you sink. But don’t lose hope! With some careful planning and smart moves, you can escape this cycle and pay off your loan.

Understanding your entire financial picture

First things first, you need to know exactly what you’re dealing with. This means sitting down and listing all the money you owe—not just the payday loans but everything, including credit cards and other debts. Also, track all your spending and income. Seeing everything written down can give you a clear picture and a starting point for your escape plan.

Make a budget that works for you

Now that you know what you’re dealing with, it’s time to create a budget. This isn’t just about cutting out all the fun stuff; it’s about knowing how much money you have coming in and where it needs to go each month. See if there are any non-essential expenses you can reduce or cut out entirely, at least for a while, like eating out less or pausing subscriptions you don’t use much.

Talk to the payday lenders

Reach out to your payday lenders and explain your situation. Many payday loan companies would rather help you figure out a payment plan than see you default on the loan. You might be surprised at how willing they are to work with you.

Consider debt consolidation

A debt consolidation loan is a bigger loan that you use to pay off all your smaller debts, including payday loans. This can make your debt easier to manage because you’ll only have one payment to worry about, and it might even come with a lower interest rate. Just be careful to read all the fine print and make sure you’re actually saving money in the long run.

Get expert advice

There are many excellent professionals out there who specialize in helping people get out of debt, such as accredited credit counselors, financial advisors, licensed insolvency trustees, or insolvency lawyers. These trusted parties can offer advice, help you make a plan, and sometimes even talk to your lenders for you. Many of these services are free or low-cost, so don’t hesitate to reach out. Plus, they’ll talk to you in a way that’s understanding and private, so you don’t have to worry about being judged.

Remember that escaping a payday loan cycle is a marathon, not a sprint. It will take time, and there will be challenges, but staying focused on your goal will help you get through it. Celebrate your progress along the way, and keep reminding yourself of the financial freedom that awaits you at the end of this journey.

How can I get ahead of this for the long term?

Keeping yourself free from a cycle of debt over the long run needs a bit of careful thinking, sticking to a plan, and making smart money choices. Start with setting aside some money for emergencies in a savings account to help you cover any expenses if something unexpected happens, so you don’t have to borrow money. You can start small and slowly save more over time to build up your slush fund.

Having a budget is super important, too. It’s basically a plan that shows how much money you have coming in, what you need to spend it on, and how much you can save. Updating your budget once in a while helps make sure it still fits your life and your goals.

Usually, and even more so when times are tough, like during a recession, the fastest way to deal with debt is to pay off the debt that costs you the most in interest first. If you’re currently carrying credit card debt, focus on trying to pay it down as much as possible. That way, if you find yourself in a pinch, you can take a cash advance on your credit card and not find yourself in a Money Mart. The hard reality is that this, too, is a cycle of debt, but at a much lower cost than resorting to predatory payday loans.

And if all of this seems a bit overwhelming, don’t be afraid to ask for advice from a financial expert. They can give you personalized tips and help you build your financial plan based on your own situation and goals.

Rebuild your credit with KOHO

If you’ve broken out of the debt cycle and are ready to start rebuilding your credit, look no further than KOHO. KOHO has a Credit Building tool that makes it easy and free to improve your credit score. This tool is great for anyone in Canada looking to start or rebuild their credit history. The best part? It’s super user-friendly. You don’t need to put down any money upfront, there’s no need for credit checks, and you don’t even have to fill out any long forms. Plus, everyone gets approved.

Here’s how it works: you give KOHO a little bit of info about yourself, and they do a soft credit check to decide on a balance for you. Then, KOHO tells the credit bureaus about this small amount of money each month as if you’re paying it back, which helps build up your credit history. You can also keep an eye on yourcredit score for free right from KOHO’s app. We all know having a low credit score can be a headache, but KOHO offers a safe and easy way to help you fix it.