Payday loans are a type of short-term loan that is typically repaid on the borrower’s next payday. While they can be a useful tool for those who need quick access to fast cash, one question that often arises when it comes to payday loans is whether they can affect your credit rating. In this article, we’ll take a closer look at the relationship between payday loans and credit scores.
What Is A Credit Score?
Before we dive into the relationship between payday loans and credit scores, it’s important to understand what a credit score is and how it’s calculated.
Your credit score is a number that reflects your creditworthiness. It’s based on your credit history, which includes information such as your payment history, the amount of debt you have, the length of your credit history and the types of credit accounts you have.
Credit scores are typically calculated by credit bureaus, such as Equifax, Experian and TransUnion. The most commonly used credit score is the FICO score, which ranges from 300 to 850. The higher your credit score, the better your creditworthiness, and the more likely you are to be approved for credit at favorable terms. This includes lower interest rates and a longer loan term.
How Do Payday Loans Work?
Payday loans are designed to provide short-term financial relief to borrowers who are in need of cash. They are typically used to cover unexpected expenses, such as a car repair or a medical bill.
To obtain a payday loan, applicants need to be aged over 18 years old, have a stable income and live checking account for the funds to be deposited into. They also need to have a Driver’s License or State ID to confirm their identity. The borrower must also be able to repay back their loan on dates agreed upon in the loan contract, typically after they receive their next paycheck on their upcoming payday.
Payday loans are known for their high fees, which can be as much as $15 per $100 borrowed. This means that if you borrow $300, you could end up paying as much as $45 in fees alone.
How Do Payday Loans Affect Your Credit Score?
Now that we understand what payday loans are and how they work, let’s take a closer look at how they can affect your credit score. It is important to understand that payday lenders do not typically report to the major credit bureaus. This means that taking out a payday loan is unlikely to have a direct impact on your credit score.
However, there are some indirect ways that payday loans can impact your credit score. For example:
Late Payments
If you’re unable to repay your payday loan on time, you may incur late fees or even default on the loan. This can be reported to the credit bureaus and could have a negative impact on your credit score.
Collection Actions
If you default on a payday loan, the lender may send the debt to a collection agency. This can result in collection actions, such as phone calls and letters, which can also be reported to the credit bureaus.
Overdraft Fees
If you write a post-dated check for your payday loan and it bounces, you may be charged an overdraft fee by your bank. This can also be reported to the credit bureaus and could damage your credit score.
Debt-To-Income Ratio
Payday loans are typically small loans, but if you have multiple payday loans or other high-interest debts, they can add up quickly. This can impact your debt-to-income ratio, which is a key factor that lenders consider when evaluating your creditworthiness.
It’s also worth noting that while payday lenders do not typically report to the major credit bureaus, they may use alternative credit reporting agencies. These agencies may track payday loan activity and use it to create a credit report or score.
What Are Alternatives To Payday Loans?
While payday loans can provide quick access to cash, they come with high fees and the potential to trap borrowers in a cycle of debt. If you’re considering a payday loan, it’s important to weigh the costs and risks against the benefits.
If you need money now, there are alternatives to payday loans that may be a better fit for your needs. Some options to consider include:
Personal Loans
Personal loans are typically unsecured loans that are repaid over a longer period of time than payday loans. They may have lower interest rates and fees, making them a more affordable option for some borrowers.
Credit Cards
If you have good credit, you may be able to qualify to get a credit card with a low interest rate or a 0% introductory APR. This can provide you with access to cash without the high fees associated with payday loans.
Credit Counseling
If you are struggling with debt, credit counseling may be a helpful resource. A credit counselor can work with you to create a budget and develop a plan to pay off your debts.
Community Assistance Programs
Many communities have assistance programs that can provide financial help to those in need. These programs may include food banks, utility bill assistance and emergency cash assistance.
Borrow Money From Family And Friends
You could also consider borrowing cash from close family or friends as this offers a quick and easy way to get the funds that you need, with potentially no interest or fees. Just make sure that you create a repayment plan to avoid any tension or strains in your relationship.
Final Thoughts
While payday loans do not typically impact your credit score directly, they can have indirect effects on your creditworthiness. Late payments, collection actions, overdraft fees and a high debt-to-income ratio can all impact your credit score and make it more difficult to qualify for credit in the future.
If you are considering a payday loan, it’s important to weigh the costs and risks against the benefits. There are alternatives to payday loans that may be a better fit for your needs, such as credit cards, credit counseling and community assistance programs.
Remember, the best way to maintain a good credit score is to pay your bills on time, keep your debt levels low, and maintain a long and positive credit history. By making smart financial decisions and using credit responsibly, you can build a strong credit score that will serve you well in the years to come.
