In a perfect world, you’d have a robust rainy day fund for life’s curveballs. But many people live paycheck to paycheck and aren’t prepared for surprise expenses. A 2012 study from the Financial Industry Regulatory Authority found that 40% of Americans would have a hard time pulling together $2,000 within 30 days to handle an emergency.
Even though most people have multiple options in such situations, many turn to one of the costliest short-term financing methods around — payday loans. Before you go down that road, learn why payday loans should be avoided, plus some of the best and worst alternatives.
Payday loans are small, short-term loans that are easily obtained because the lender rarely checks the borrower’s credit. Simply write a post-dated check for the amount borrowed or hand over your bank account information plus a sizable fee, typically $15 per $100 borrowed, and you walk away with a few hundred dollars. When the loan comes due, generally in two weeks, you pay the money back. Or the debt can be rolled over, delaying repayment in exchange for more fees.
Here’s the problem: The hefty charges imposed by lenders make the effective interest rate exorbitant. A $15 fee to borrow $100 may look like 15% interest, for example, but it’s really equivalent to a 390% annual rate — more than 10 times the typical rate for a credit card cash advance, itself an expensive option. According to a Pew Charitable Trusts study in 2012, the average payday loan borrower took out eight loans of $375 each per year and paid a whopping $520 in interest.
Getting just one payday loan won’t ruin you, says Johanna Fox Turner, a certified public accountant and financial planner at Milestones Financial Planning in Mayfield, Kentucky. “The problem is that once you do it once and see how easy it is, it’s a lot easier the next time. … But these loans are a quick Band-Aid for a hemorrhage instead of a cure for the underlying problem,” she says
More than 80% of payday loans are renewed or followed by a subsequent loan within two weeks, the Consumer Financial Protection Bureau said in a 2014 report. That agency has warned that these loans quickly turn into a vicious cycle, making it very difficult to pay off the debt.
Payday loan alternatives
There are many better options than payday loans — plus a few that may be even worse. Here are some alternative strategies for getting through a financial emergency.
Personal loans: Unsecured loans — or “personal loans” — from banks and credit unions are preferable for those with access to these sorts of lenders. They typically come with a fixed interest rate and require the borrower to repay the debt with a set monthly payment. Finance companies offer similar products, called installment loans.
“Traditional installment loans are the best alternative to payday loans for consumers because they provide consumers a clear roadmap out of debt through manageable equal monthly payments that pay off both principal and interest,” says Karen Klugh, a spokeswoman for the American Financial Services Association, an industry group. She says consumer finance companies determine the borrower’s ability to pay and report the debt repayment to the major credit-rating companies, which can help the borrower build a good credit score.
Installment loans also give you much more time to pay back the debt, says James Chilton, founder and chief executive of the Society for Financial Awareness, a nonprofit group focused on financial literacy. This financing also generally lets you borrow more and at significantly lower rates than payday loans.
You also may be able to borrow through local community organizations or find other short-term assistance. NerdWallet has gathered a database of payday loan alternatives available to residents of California and Texas, but if you live elsewhere you may find local churches may make small loans at very low rates to help members avoid payday loans. Ask your house of worship if it offers small emergency loans; it also may be able to point you toward other resources.
Borrowing from retirement accounts: Pulling funds temporarily from an IRA or a 401(k) plan is another option. Although you’re borrowing from yourself instead of a lender, it’s not without risk. You can borrow from your IRA penalty-free once a year if you put the money back within 60 days. If you miss that deadline, you’ll have to pay income tax on the money, plus a 10% penalty on the amount if you’re under age 59½.
If your employer allows 401(k) loans — and not all do — you can typically borrow as much as half your account balance, up to $50,000, and you have five years to repay it. However, if you don’t make payments for 90 days, it’s considered taxable income and treated like an unrepaid IRA loan. Also, borrowing from a 401(k) plan could mean paying interest on the debt and missing out on investment returns the borrowed money might have produced. If you leave your job, you may have to repay the 401(k) loan within a certain time period or face fees and taxes.
Payroll advance: Ask your employer for a cash advance on your pay, which usually doesn’t cost you any fees. Some companies also offer low-cost loans to workers in crisis situations. If you’ve been a good employee for several years, these can be excellent options, Turner says.
“Employers, especially small-business owners, are usually very sympathetic to their employees and willing to help if they can spare the cash,” she says.
Credit card cash: If you have a credit card and the account is in good standing, this is an option, but it’s expensive. You’ll pay a fee, typically around 5% of the amount borrowed, plus interest, which can be around 30%. Even at that rate, though, this is still much less costly than a typical payday loan.
Borrow from friends or family: Try borrowing from people you know, Chilton says. Relations and pals can offer unmatched flexibility, but be aware that a debt can complicate those relationships.
Bill forbearance: Approach creditors that don’t charge interest, such as utility or cable-television companies, and find out whether they’ll accept delayed payments. Use whatever money saved from not paying those bills to cover emergency needs. People who already have loans outstanding could ask for modifications on the debts to help free up more cash.
Short-term account advance: Some banks and credit unions offer small, short-term cash advances as payday loan alternatives. While the costs may not be quite as steep, they can still be quite expensive. Credit unions can’t legally charge more than a 28% annual percentage rate on small, short-term loans, so they may also be more affordable than banks.
Borrow against life insurance: Chilton says borrowing against a whole life insurance policy can be one of the best solutions for those in a bind, if your policy allows it. “The insurance company will give you your entire life to pay the loan back, and if you don’t, upon your death, they just subtract the money from the policy amount,” he says.
Online alternatives: Borrowers with credit scores below 630 or so may have a hard time finding a personal loan, but it’s worth the effort to look. Some online providers approve borrowers with scores below that mark; they’ll also look at your debt-to-income ratio. The payoff is that these lenders’ rates typically are capped at 36%. Those who can’t qualify with one of those lenders might consider LendUp, which provides installment loans at a lower cost than payday outlets, and Activehours, which pays hourly wage earners the same day they work.
Pawnshops: Pawnshops may seem sketchy, but you can legitimately get money quickly if you have something valuable you won’t need for a certain amount of time. Their collateral-based loans are regulated differently state to state, so finance charges can vary greatly. But this alternative can be better than a payday loan. There are also online pawnshops offering loans for your goods, includingBorro.com, geared toward luxury items such as jewelry, artwork — even handbags and wine.
Auto title loans: These short-term loans, where they’re legal, require you to hand over the title to your vehicle as collateral for the debt. They’re often compared to payday loans, and the interest rates are comparable, but they can be even worse: If you don’t repay, the lender can seize your car.
The bottom line
If you have no alternative but to borrow, a personal or installment loan is preferable to most other alternatives, though good credit is required. Those whose credit is lacking should consider all alternatives before opting for a payday loan and risk getting caught in a vicious cycle of debt.
This article was updated May 26, 2016. It originally published March 11, 2015 in NerdWallet.