"It is important to know that millions of Americans rely on payday loans each year to handle emergencies." says Carey Zielke, personal finance expert for Realities and Dreams.
Payday loans are often referred to as predatory, but they still stick around in America.
According to a Federal Reserve report released in May 2019, four in ten adults would have difficulty covering an unexpected $400 expense. Twelve percent of adults would be unable to pay the expense by any means, and 2 percent would use a payday loan, deposit advance, or overdraft their accounts to cover the expense.
A term common in the short-term lending industry is a payment rollover, or a loan rollover. This is when a borrower can't make the payment in full and takes an option to roll the loan payment over, for more time to pay it off. To consumers who rely on short term lending, a rollover can be helpful, but also harmful. Let's explore how and why.
How does a loan rollover work?
"First, we need to clear up the term rollover," says Zielke. "A payday loan rollover can mean two different things:
- Consolidate the loan into an installment loan.
- Pay the outstanding interest and extend the due date."
In addition to these two instances, there is a third that is common in the payday lending industry. Jacob Dayan, CEO and co-founder of Community Tax and Finance Pal explains, "Another way to roll over a loan is if the borrower takes out a new loan in order to cover the previous loan."
"The second option, and most common," says Zielke, "is accompanied by a fee, usually an interest rate increase."
To better understand what this means, Zielke shares an example:
"Basically, if you have a $300 payday loan with a 15 percent interest rate on a 14-day term, you can pay $45 to extend the due date another 14 days. The fee for this will be an interest rate increase, most likely another 15 percent.
The loan interest rate is now 30 percent. If you still can’t afford to pay it off, you can roll it over again by paying the $90 of interest, for 14 more days. Now your interest rate will be 45 percent."
With a rollover, the cost of a short-term loan can clearly add up. Essentially, you are paying more money so that you can delay your payment, says Xavier Epps, founder and CEO of XNE Financial Advising. He adds, "You will still owe the same principal and fees associated with the loan. If you are seeking to rollover your loan, expect to end up paying more than what you would have paid, had you originally finished paying the loan off on-time."
Are loan rollovers regulated?
Robert L. Föehl, Esq., Executive-in-Residence for Business Law and Ethics at Ohio University explains, "The federal Consumer Financial Protection Bureau and states have been particularly concerned about payday lending activities, including rollovers. A number of states require a ‘cooling off’ period after a payday loan comes due. This is a period that must elapse before a borrower can roll over the payday loan. The CFPB has issued a rule related to various aspects of payday lending as well."
When is a loan rollover helpful?
To help us understand how and when this loan option can be a positive thing for consumers, Professor Foehl, shares some details: "The helpful aspect of payday loan rollovers is that they enable borrowers to extend the repayment period of their loan. This is particularly helpful when the anticipated source of funds for repayment doesn’t materialize for the borrower."
"For example," he says, "a borrower may take out a payday loan for emergency car repairs, believing that the short-term loan can be paid in full from the borrowers upcoming paycheck(s). However, the borrower may not be able to work the regular number of hours he usually works because of the lack of reliable transportation. As such, the actual paycheck is less than what was initially anticipated."
Föehl adds, "It is important to remember that payday loans are designed primarily for individuals who are living paycheck-to-paycheck and qualify for few, if any, other types of credit products. Payday loans exist to serve these individuals, who are underserved by traditional lenders."
These are people with bad credit or no credit score, also known as credit invisible or credit unscorable consumers.
When is a loan rollover harmful?
Just as a loan rollover can be helpful to the consumer who is having trouble making a loan payment in full, there are also times when it can really harm a borrower's finances. Professor Foehl explains, "The concern with payday loan rollovers is that they are usually accompanied by additional fees (after all, the payday lender needs to be compensated for the additional risk of loan default). These fees are usually rolled over into the new loan. In the circumstance where the borrower hasn’t made any payment toward the loan, the loan amount actually increases."
Now imagine how hard it would be to make the payment, if your loan keeps growing, but your earnings stay the same. "Multiple rollovers exacerbate the problem," he warns. "A borrower can get into a cycle of rolling the loan over and over, increasing the loan amount due to the additional fees, until the borrower is unable to pay back the total amount lent."
What is a cycle of debt?
"A loan rollover is harmful because it can lead to a cycle of debt," explains Dayan. "If the borrower is unable to pay off their debt, they are continuously trying to extend their loan due date or take a new loan in order to pay the first loan off. By choosing to rollover their loan, the amount they're borrowing increases and it will become difficult saving enough money to pay off the entire loan."
Sara Nelson-Pallmeyer is Executive Director of Exodus Lending, a non-profit that helps consumers refinance these expensive loans. As a non-profit, Exodus charges no interest or fees. She explains a bit more about how one rollover can easily put someone into a cycle of debt: "Loan rollovers are the result of people not being able to repay their payday loan, including hefty fees, which are due in full on one's next payday. Borrowers end up taking out a second loan to repay the first, a third to repay the second, a fourth to repay the third, and so forth. Each of these new loans (after the first) is a rollover."
"Typically," she adds, "people end up spending more in interest and fees for their loans than the amount that they borrowed in the first place."
What can borrowers do to stay safe?
As we mentioned before, payday loans exist because people without any access to mainstream credit need them. We asked our financial experts for advice on handling or managing payday loan rollovers and personal finances. Here's what they said:
Nathan Wade, Managing Editor for WealthFit Money
"The biggest reason why you shouldn't take part in a loan rollover is that you will have to pay more long-term. Although it may seem beneficial in the moment since you will have more time to pay it off, you're having to pay more. "
"Don't borrow with credit cards. If you can't pay your credit cards in full every month then you probably shouldn't be using one. Utilize cash or a debit card until you're comfortable with your spending. Create a spending plan that lays down how much you can spend and how much you're actually spending. Start by budgeting living needs such as food and housing, then start to include expenses that you need and not just 'want.' This means you might have to change your spending habits, like canceling cable services. You should also pay attention to how many times you eat out or attend expensive events. Making these small changes can make a huge difference in your budget and help you escape the cycle of debt."
Xavier Epps, founder and CEO of XNE Financial Advising
"Make sure that you do not frequently roll over your loans your total balance can quickly increase by hundreds."
Carey Zielke, Personal Finance Expert, Realities and Dreams
"My number one recommendation for everyone is to save some money, three to six months of living expenses as an emergency fund. I understand that will take a substantial amount of time to accomplish, and sometimes is not even possible depending on our financial situations.
To start this process, at an absolute minimum, save up $1,000, and use it ONLY for emergencies!"