Every now and again, we all find ourselves in a financial pinch. When you are strapped for cash, it can be tempting to turn to payday loans. These loans are known for not being too picky about poor credit, and you can get the cash fast. If you're not careful, though, you could find yourself in big trouble down the road.

According to the companies that offer them, payday loans fulfill a need in society. And, to a certain extent, this is true. There are those who don't have good enough credit to qualify for “regular” personal loans from banks, or credit cards from issuers. If someone wants or needs cash fast, and his or her credit is bad, there is little option beyond turning to a payday lender.

However, you do need to be careful if you find yourself in a position to get a payday loan. Even though it seems necessary, there are some definite pitfalls associated with with payday loans. Here are some of the reasons they are so dangerous:

Short Term, High Interest Loans

Payday loans are short term loans made by companies in Canada like Money Mart and The Cash Store at very high interest rates. These loans are meant to just get you through until payday, hence the name. Few people, when getting payday loans expect them to last very long, especially since they often mean to immediately pay off what is owed once payday arrives.

Here's how it works: A borrower writes a personal cheque for the loan amount, plus a fee, payable to the lender. The lender holds the cheque until the borrower’s next payday and then deposits it in the bank if the borrower hasn’t paid by cash before that date. If there are insufficient funds in the borrower’s account, they will owe a return fee to the payday lender and an NSF fee to their bank. The borrower might then take out another payday loan to pay off the original loan.

One of the biggest pitfalls associated with payday loans is the high interest rate. Not only can a payday loan turn into long term debt, but the interest you pay is astronomical. The fees for payday loans are between $51 to $72 on a $300 loan. This works out to an APR (annual percentage rate) of 443% to 626%. As you can see, your short term loan comes with a high cost.

These interest rates mean that you are paying money into someone else's pocket, instead of using the money to benefit you. Paying high interest is a major drain on your wealth, and can lead to a worse financial situation later.

If you are caught in the cycle of high interest debt, it is difficult to get out because so much of your payment is going to interest, rather than reducing the principal. You continue to make payments, but the actual amount that you owe is reduced at a very slow rate. Imagine what you could do if that interest was placed in a TFSA, instead of lining someone else's pockets.

Payday Loans are Easy to Renew

There are also often chances to renew the loan. If you are willing to come in and pay another fee, the company often agrees to hold the cheque for another pay period. As you can see, unless you change your money habits, this short term loan becomes a long term loan. In some cases, you can renew almost indefinitely. The payday loan company makes a great deal of money as you pay a fee every couple of weeks to extend your loan.

Payday loans are so dangerous in terms of high interest rate because they are so easy to renew. Most payday lenders will let you renew your loan for another two weeks, or month, simply by making another interest/fee payment. If you borrow $200 for two weeks, you might pay a $20 fee now, and then be expected to pay the $200 later. However, when the due date comes around, you realize you still don't have the $200. You either end up defaulting, or you can extend by paying $20. It seems easier to pay the fee to keep extending, because it's a smaller and much more manageable amount.

On top of that, some payday lenders will allow you to borrow even more when you extend. So you pay a slightly bigger fee, but you are able to borrow more money, and you can soon find yourself extending that term out as well. You can see how this begins to be a trap. If you borrow a significant amount of money from a payday lender, you might never — without some serious changes and hard work — actually have the lump sum you need to pay off your obligation. But you can keep making smaller payments. After a few months, you've paid enough in fees to have gotten rid of the loan amount, but since you're only paying fees (and not principal), you still owe just as much.

Payday Loan Companies Cash In

What makes me most concerned about these companies is that as financial concerns continue and banks restrict their lending, the payday loan companies I mentioned above both had double digit revenue increases this past quarter over the previous year. These revenues are made from the increasing number of people that believe they have no other options for paying their bills and rent.

It's clear that payday loan companies serve a need. Consumers who can't access lower cost options are forced to turn to payday loan companies. As they continue to struggle, the situation only worsens. Unfortunately, many payday lenders take advantage of these situations. They know that their customers have no place else to go, so they basically engage in gouging behaviour, charging extra for this service.

While some might argue that payday loan companies have to charge high rates in order to cover their risk of default, there are those that think that some of the rates and fees are excessive. You could charge a higher interest rate and offset some of the default risk without making it obscene.

Those who can't afford their payday loan payments can find their credit damaged. In fact, it might be a little damaged anyway, since credit scoring algorithms consider the source of the debt, as well as whether or not you pay. A payday loan isn't scored as highly as a loan from a reputable lender for something like a car. If you habitually get payday loans, your credit might suffer.

What To Do Instead of Getting a Payday Loan

Getting a payday loan is easy, there are even online payday loans available now. But this ease, along with the high interest rates and the ability to renew your loan, can cause problems for your finances. Payday loans can be dangerous to your finances if they become a habit.

If you find yourself facing a financial dilemma, it's important to avoid getting a payday loan if at all possible. Instead, turn to friends and family, and find out if there are community programs that can help you. You can also try a bank loan, or even using a low interest rate credit card, almost any loan is better than getting a payday loan.

Only get a payday loan if you are sure that you have no other choice… and even then think twice.

About Tom Drake

Tom Drake is the owner and head writer of the award-winning MapleMoney. With a career as a Financial Analyst and over eight years writing about personal finance, Tom has the knowledge to help you get control of your money and make it work for you.

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