If you're strapped for cash, payday loans aren't the only financial product to be wary of. Consumer advocates say there's a new, similar product, online installment loans, that can also be ruinously expensive for borrowers and tough to recover from.
"We call these long-term payday loans," says Lauren Saunders, associate director at the National Consumer Law Center in Washington, D.C., about online installment loans. "Even though the interest rate may technically be lower, these are actually a bigger and deeper debt trap than traditional, 300% APR payday loans."
Here's what you need to know.
Many people are familiar with traditional installment loans. Most loans, including mortgages and auto loans, are paid off in installments, or on a monthly payment schedule.
Online installment loans are similar. The key difference is that lenders market high-interest installment loans to people with bad or no credit, typically with high fees and high interest rates attached. In that way, consumer advocates warn, these loans are similar to payday loans — short-term, high-interest loans available to almost everyone, even those with bad or no credit.
Online installment loans, then, are something of a combination of a payday loan and a traditional installment loan.
The Community Financial Services Association of America, a trade organization that represents the payday lending industry, argues small-dollar lending is an economic necessity for many households, with its data showing that 12 million households use payday loans annually.
But payday loans tend to be expensive, and they can lead to a cycle of debt that's hard to escape. Consumer Financial Protection Bureau data shows that nearly 25% of payday loans are recycled, or reborrowed, at least nine times. Data from Pew says it tends to take around five months for borrowers to pay back a loan, so borrowers end up paying an additional $520 in fees, on average.
In recent years, state and federal agencies like the CFPB have cracked down on the payday loan industry. "All of the payday lenders could see what was coming, and a lot of them adjusted," says Lisa Servon, a professor at the University of Pennsylvania whose areas of study include urban poverty and economic development.
As a part of that adjustment, Servon says, "some of those lenders started looking at online installment loans."
Online installment loans can make borrowers feel that they have more control over their debt and that they'll end up paying less. Consumers pay the balance back over several months, as opposed to one or two payments for traditional payday loans. And interest rates for online installment loans tend to be lower than payday loans, at least on the surface, with a typical rate cap of 36%.
But rates vary from state to state and, depending on where you live and how good your credit is, you could end up taking out a loan for more than $10,000 at an annual interest rate of 155%.
Saunders says that often borrowers end up paying more than 100% interest and find themselves recycling the loan when they can't afford to pay it off or make their scheduled payments. It's essentially the same debt cycle that many people find themselves in when taking out payday loans.
Video by David Fang
Lenders use a key tactic to maximize profits from online installment loans: They ask that borrowers sign up to make automatic payments from their checking accounts. That, coupled with high interest rates, can put borrowers in a bind.
Borrowers who allow lenders to automatically pull payments lose the flexibility to make payments when they feel they can afford it, and they run the risk of overdrawing their accounts. That could lead to additional bank fees, which can cost even more money.
Lenders "encourage people to set up automatic repayment from their bank account," Saunders says. "That makes it easy for the lender to collect, but may leave the consumer without money to pay their regular expenses."
Many financial professionals recommend that consumers avoid high-interest loans at all costs. "My advice for consumers is to stay away from any loan that is over 36% [interest]," says Saunders, "and any loan that you can't clearly see what the interest rate is."
Unfortunately, there aren't a lot of places for consumers to turn when they need funds quickly. They can always shop around at banks or ask a family member, but Servon says that borrowers looking for payday or online installment loans have already exhausted most of their options.
"People have gone through the alternatives" like credit cards or borrowing money from friends and relatives, she says. So, for these borrowers, online installment loans are "sort of like a loan of last resort."
Still, experts say that consumers who need to take out a payday or online installment loan can take steps to make smarter borrowing decisions and avoid a debt trap. Keep track of what you need to pay, when you need to pay it, and calculate how much you'll actually end up spending in order to borrow that money. It's also a good idea to save up an emergency fund to avoid being in a position in which you need to go into debt.
"Read the fine print," says Katie Brewer, a Dallas-based certified financial planner who runs the financial firm Your Richest Life. Payday or online installment loans may be a viable option if "you understand what you're getting into," she says.
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