Are Payday Loans Beneficial for Your Credit Score?

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Dawnesha Burns Jul 08, 2024

Millions of Americans have their budgets scheduled from paycheck to paycheck. Unless there are unexpected expenses or unplanned purchases, there are no problems. However, there may be situations when there is insufficient money until the next paycheck. As borrowing from family or friends is not always an option, many people turn to payday loans.

While most customers know these loans have high interest rates and short repayment terms, only some of them consider how they can affect their credit history. The question is "If you approach these loans responsibly, can they build a credit rating?" And will your credit history worsen if you repay late? In this article, we provide the answers and show how to minimize risks associated with this type of lending.

Table of Contents

1. How Do Credit Scores Work?
2. How Do Payday Loans Function?
3. How Do Payday Loan Lenders Assess Your Credit History?
4. Is It Possible to Build Credit with a Payday Loan?
5. Potential Dangers of Payday Loans
6. Strategies to Protect Your Credit Score When Using Payday Loans
7. Viable Alternatives to Payday Loans
8. Bottom Line
9. FAQ

How Do Credit Scores Work?

Credit rating indicates the borrower's creditworthiness and the reliability of managing their debt obligations. It is formed based on information from credit reports - each loan repaid on time increases it, while overdue debts or a large number of loan requests, on the contrary, worsens it.

A good credit history opens up many opportunities. With it, you can take out a loan for a large amount at favorable interest rates, take out insurance cheaper, and also increase your chances of employment. With a damaged credit history, banks and other institutions may consider you risky, which will lead to less reasonable terms.

In addition, for some lenders, a lack of credit history (if you have never had any loans or credit cards) is also a negative indicator: nothing is known about you yet so you can appear to them as a potentially dangerous borrower.

How are Credit Ratings Formed?

Your credit score is calculated based on five important things in your credit history:

• How often and on time do you pay your bills?
• How much credit do you have compared to your credit limit?
• How long has it been since you opened your credit accounts?
• What types of credit accounts do you have?
• How many times have banks made inquiries about your credit history?

You can only reach a good credit score if you manage these metrics well. Your payment history (35%) and credit utilization (30%) impact your score the most, while the length of credit (15%), variety of credit accounts, and number of inquiries (about 10% each) have a smaller impact.

Beginner's Overview of FICO and VantageScore Credit Scoring Systems

FICO and VantageScore are two models lenders use to evaluate your credit history. They both have a scale from 300 to 850 but consider different things. Here's a comparison of FICO and VantageScore credit scores:

How Do Payday Loans Function?

Payday loans allow you to deal with unexpected expenses without waiting for your next paycheck. Typically, you have 14-30 days to repay the loan. You need a stable income and a valid bank account to apply for a payday loan. The lack of a credit check makes the approval process quick and easy.

Payday loan sizes range from $100 to $1,000. This depends on state law, the borrower's income, and credit rating. Annual interest rates often exceed 400%, significantly higher than on traditional banking products. This is due to the high risks for lenders.

As these loans have high APRs and short repayment terms, people are often forced to take out new loans to pay off old ones, which leads to ever-growing debt. Each state has its own rules for the payday loan market. Some states have caps on interest rates and maximum loan amounts or even completely prohibit payday loans to protect consumers from going into debt.

How Do Payday Loan Lenders Assess Your Credit History?

Online lenders run what's known as a "soft credit check," enabling them to evaluate your repayment capacity without obtaining specific information from credit bureaus. The soft check has no negative effects on your credit score. Instead, online lenders base their loan decisions on the borrower's current income, not on past financial mistakes.

Is It Possible to Build Credit with a Payday Loan?

If the online lender reports to the credit bureaus, timely repaying a payday loan can help you build or improve your credit history. However, finding such lenders can be difficult since most do not report your on-time payments to the credit bureaus. Therefore, your credit score will not improve even if you manage your loan responsibly. However, if you default on your loan, it may eventually be referred to a collection agency, harming your credit rating.

Potential Dangers of Payday Loans

Payday loans can be a quick solution for immediate financial needs but come with significant risks:

High Interest Rates

Payday loans rank among the most expensive loan options due to their exorbitant annual percentage rates, which can exceed 400%.

Short Repayment Terms

These loans have a short repayment period of two to four weeks. This can make it difficult to repay the loan on time, resulting in additional penalties and higher costs.

Debt Cycle

Borrowers typically need more time to repay the loan in full. This can lead to a cycle of borrowing, when they take out new payday loans to cover the old ones, accruing more debt over time.

Hidden Fees

Payday loans can come with some hidden expenses, such as rollover, late, and application fees. These charges can significantly increase the total cost of the loan, in addition to their high APRs.

Impact on a Credit Score

Although payday lenders generally do not report to the major credit bureaus, failing to repay a loan can lead to the account being sent to collections. This can negatively impact your credit rating.

Risk of Bank Account Overdrafts

Many payday lenders need access to your bank account to execute automated withdrawals. This could result in overdraft fees if a lender tries to collect payments while your balance is insufficient.

Strategies to Protect Your Credit Score When Using Payday Loans

To prevent payday loans from harming your credit rating, follow these guidelines:

1. Borrow Only What You Can Pay Back

Before applying for a loan, evaluate whether you can repay the loan amount and interest before your next paycheck. Only borrow what you can afford.

2. Understand the Loan Terms

Make sure the lender does not charge additional fees. Read the contract, talk to the lender, and understand the interest rates, extra costs, and repayment terms.

3. Budget for Repayment

Create your monthly budget to repay the debt within the prescribed time frame. Reduce unnecessary expenses so you don't face financial problems when paying off your payday loan.

4. Communicate with the Lender

If you have difficulty repaying your payday loan, contact your lender and explain the problem. Some loan providers accommodate borrowers by offering loan extensions or deferred payments. Communication will help you avoid late payments and problems with your credit history.

5. Use Payday Loans in Exceptional Cases

Consider alternatives, such as loans from credit unions or financial assistance from loved ones. Avoid payday loans when possible so as not to go into debt.

Viable Alternatives to Payday Loans

A payday loan can help quickly solve money problems. But first, it's worth considering safer alternatives that cost less and allow you to build a credit history. These options include:

Personal Loans

Personal loans allow you to borrow larger amounts ($1,000 to $50,000) and offer a lower interest rate (5.99%-35.99). Debt repayment also takes more time - from 1 to 5 years. The main advantages of a personal loan are fixed interest rates and monthly payments, which will help you plan your budget. Still, you need to have a good credit history to get more favorable conditions.

Credit Union Loans

Unlike traditional bank loans, credit union loans have more favorable interest rates and simpler eligibility requirements. They usually give out smaller loans, typically up to $10,000. They also have flexible rules and treat you more personally as a co-owner. The main downside is that you have to be a credit union member, and they might not give out as much money as other lenders.

Credit Card Cash Advances

With credit card cash advances, you can immediately get cash via an ATM or bank store. However, the interest rates are usually higher than what you pay for regular purchases with your card. There are also fees, usually 2-5% of the amount you borrow. The good part is you get cash fast without filling out any forms. The downside is that interest rates and fees start adding up right away.

Peer-to-Peer Lending

P2P platforms connect people who need to borrow money with individuals who want to invest. These platforms give you interest rates based on how trustworthy you seem. You can usually borrow between $1,000 and $40,000. A good credit score may be needed to get the best deals, and there's a chance you might not get a loan if investors aren't interested in lending to you.

Family and Friends

Borrowing from family and friends means getting a loan based on personal relationships, without formal procedures like credit checks or paperwork. You work out the terms and interest rates directly with them. The good things are flexible terms, lower or no interest rates, and emotional support. However, the lack of formal agreement can cause misunderstandings. It can strain relationships if problems with paying back the loan arise.

Salary Advances

The main benefit of salary advances is that they provide immediate access to needed funds without incurring interest charges. However, they are limited to a portion of your earned wages and reduce your next paycheck, which can put you in a difficult financial position. There may be a service fee.

Government Assistance Programs

Government assistance programs give grants or loans at low interest rates. They're often for low-income people or specific things like housing or utilities. To get help, you usually need to apply and show why you need it. Grants are great because you don't have to pay them back; they help with important things. However, applying can take a long time, and there might not be enough money for everyone who applies. Plus, the rules about who can get help are strict.

Bottom Line

Refrain from relying on a payday loan to improve your credit rating. Online lenders don't report to credit bureaus, so paying off your debt on time won't improve your credit rating. It's better to consider alternatives.

If a payday loan is your only option, pay it off responsibly so your credit rating doesn't suffer. If you have a low credit score, improve it so you can be more eligible for credit in the future.

FAQ

How Long Can Payday Loans Affect Your Credit?

Overdue payday loans usually stay on your credit report for about seven years if the lender or collector reports your default to credit bureaus. On-time payments typically leave no entries on your credit report.

Are Payday Loans for Low Credit Scores?

Yes, online lenders do not perform a hard credit check but focus on the client's income. This allows people with bad credit histories to get payday loans.

Why Are Payday Loans Bad?

Payday loans are questionable and require thorough consideration. They can charge fees of $10 to $30 per $100 borrowed (depending on the state and lender), which equates to an annual percentage rate of 400% or more.

So, for a $700 loan, you could pay between $70 and $210 in interest. Given the short repayment periods, some borrowers default on their financial obligations and end up in a debt cycle. Additionally, payday loans do not contribute to a positive credit score change but can worsen your rating if you default.

How to Steer Clear of Payday Loans?

It's helpful to create an emergency fund so you don't have to turn to payday loans to cover unexpected financial needs. It is also worth considering alternative types of lending that offer more favorable conditions and are cheaper.

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