The amount payday lenders can charge could soon be capped under plans proposed by city regulator, the Financial Conduct Authority.
Millions of people turn to payday loans to help make ends meet, but many find that they can't pay back what they owe in time. As a result, their debts soon spiral out of control owing to the exorbitant interest rates charged.
Find out how payday loans work; why they can seem attractive; and how, if you're not careful, they can be the beginning of debt problems that are much greater than your initial cashflow shortage.
What are payday loans?
Payday loans are short-term loans aimed at people who are finding it difficult to make it through to their next payday. The amounts on offer to payday loan borrowers usually range from £100 to £300, but can be as high as £1,000.
The term of the loans is almost always set at 31 days, and the money can generally be in your account on the same day as your application. However, the interest rates charged on loans of this type are much higher than those imposed by credit card companies and personal loan providers, with some in excess of 4,000%. The interest rates are set at that level because the loans are supposed to be repaid within a very short term.
If you fail to repay the full amount on the date agreed, the sky-high interest rates can cause the amount you pay to soar, leaving you with debts you can't afford to repay.
Are there any other problems with payday loans?
As well as charging high rates of interest, payday lenders often use what is known as Continuous Payment Authorities (CPAs) to collect repayments.
These effectively allow the lender to take money from a borrower's debit or credit card and to change the amount taken whenever they want.
This can make life very difficult for consumers, as CPAs are much harder both to control and cancel than direct debits.
As well as charging high rates of interest, payday lenders often use CPAs to collect repayments. These effectively allow the lender to take money from a borrower’s debit or credit card and to change the amount taken whenever they want.
Why do people take out payday loans?
The main appeal of payday loans is that you can get your hands on the cash almost immediately, which can be useful in the event of an emergency. And even though interest rates are high, many people consider it a price worth paying if they can access the money they need in just a few hours.
But they should only be considered as a last resort - if you aren't absolutely certain you can pay off what you owe within the agreed term, you could find yourself saddled with debts that become more expensive every day.
Will the regulator's new proposals help?
The FCA has proposed that payday lenders should never charge more than 0.8% per day of the loan amount. Someone who takes out a £200 loan over 30 days, and makes repayments on time, will now pay no more than £48 in interest, based on the 0.8% cap.
Currently, a payday loan of this size would typically cost at least £60 in interest, but in some cases interest costs can be more than £37 per £100 borrowed, so £74 for a loan of £200.
The FCA also said no-one should have to pay back more than twice the amount borrowed. That means if you take out a loan for £200, you will never pay back more than £400 in total, even if the loan is rolled over to the following month.
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When will the price cap come into effect?
The FCA’s plans are now being consulted on until 1 September 2014 and final rules will be published in early November. If all goes smoothly, the price cap should be in force from January 2015.
Do consumers have any other protection?
Yes, they do. Since 1 July 2014, payday lenders have had to include risk warnings in their television adverts and must tell customers where they can get free debt advice. Also, loans cannot be rolled over more than twice.
There is also now a restriction on amount of the times a lender can take money from a borrower’s account without their specific permission. CPAs can only be used twice to prevent lenders dipping into accounts to collect repayments whenever they want to.
Are there alternatives to payday loans?
Ideally, everyone should try to build up their rainy day savings, which they can dip into in the event of an emergency, rather than having to rely on expensive credit. Choose an easy access account so that you can get your hands on your money swiftly, and try to pay in something every month, however little that may be.
Remember that many of the best easy access accounts include short-term bonuses in their rates, so you will need to move your money once the bonus disappears.
But if you can't afford to build up any savings, you may want to think about a credit card that offers a lengthy 0% rate on purchases to help tide you over. However, try and clear what you owe within the 0% period, or you risk being hit with steep rates of interest.
If you feel your finances are getting out of control, seek professional help as soon as possible. Free debt charities such as StepChange, formerly the Consumer Credit Counselling Service, can provide you with impartial debt advice to help you find the right practical solution for you.
You can visit the website at Stepchange.org or call on 0800 138 1111.
The content on this page is supplied by MoneySupermarket.com.