Understanding the True Cost of Payday Loans and Cash Advances

Anyone strolling down Robson Street in downtown Vancouver may disregard this type of sale advertisement unless you happen to be a financial planner or desperate for a cash advance.   As a financial planner, I took note of this particular signage because my plans were to address this in a blog post.   But I also remembered the first time I applied for credit. I made an application for a Sears credit card and was declined.   I felt devastated and ashamed yet I trusted that the company’s reasoning must have been valid. The reason for the decline could have been missing or inadequate information and even lack of credit history.  I didn’t understand and I didn’t ask. Now I will never know.

When people are refused credit, they become desperate in times of distress.  Payday Loans and Cash Advance stores are frequently being used by people who find themselves in these types of situations. They may not fully understand the fees and true cost of borrowing from these venues.  At first glance these may sound like great deals but really aren’t.     

Calculating the Cost of Borrowing

The Financial Consumer Agency of Canada (FCAC) provides a clear illustration of the cost involved with payday loan compared to other ways of borrowing.  Undoubtedly, you can see the price difference you pay when you borrow $300 for 14 days.  This information should convince anyone from using cash stores. It’s all in the math. 



Financial Consumer Agency of Canada


The costs shown in this example are for illustration purposes only. Calculations of costs are based on the following assumptions:

• a payday loan costs $21 per $100
• a line of credit includes a $5 administration fee plus 7% annual interest on the borrowed amount
• overdraft protection includes a $5 fee plus 19% annual interest on the borrowed amount
• a cash advance on a credit card includes a $5 fee plus 21% annual interest on the borrowed amount.

 

The Good, the Bad and the Ugly

One cannot dispute the “good” about the payday loans.  They are convenient, providing quick access to money within the hour. The advertisements proclaim “no credit check”. These are probably the only visible “good” things about payday loans.

Behind the good is also the “bad”. Some people find themselves growing dependent on regular advances every payday.  When a part of a paycheque is used to pay off your debt, a person will find themselves short of money for other expenses.  Once again, they will be forced to apply for another advance. The endless cycle begins and develops into larger advances.  The associated cost takes more from their paycheque than just repaying the borrowed principal.

The “ugly” is the fees deemed to be reasonable by the Canadian Payday Loan Association (CPLA).  The cash stores make no mention of an annual interest rate since they only charge a fee for their service.  When these fees are translated into an annual interest rate, they’re ugly.   The law requires the cost of credit to be disclosed by defining the APR (Annual Percentage Rate), the rate of interest charged on a loan each year.  At the Money Mart® website, the fine print states for Saskatchewan residents, the APR on a $300.00 loan for 14 days is 599.64% on a rate of $23.00 per $100.00 borrowed.  This calculated annual interest rate of 599.64% is not a typing error.  That’s enough to blow anyone’s mind.  The cautionary message can’t be any clearer than this “Payday Loans are High Cost Loans.”   

Breaking the Cycle 

People depend on these types of loans because they may have been misled into believing their credit is poor.  Although their credit is below the standard requirement, they may not have any direction how to fix their credit score.  Any effort to improve a credit score in order to apply for a Line of Credit or Overdraft Protection at a bank or credit union will save money when borrowing is necessary.

People have also felt intimidated by financial institutions because of what others have told them or even from their past experiences. Their fears may be unwarranted.  Finding the courage to develop a relationship with someone at a bank or credit union where they feel comfortable will diminish their fears. 

In his book, The Success Principles, Jack Canfield emphasizes taking 100% responsibility for your life.

Don’t be afraid to ask. Most people are afraid to ask for feedback about how they are doing because they are afraid of what they are going to hear.  There is nothing to be afraid of.  The truth is the truth.  You are better off knowing the truth than not knowing it.  And once you know, you can do something about it.

Fixing the Problem

The only way to wean oneself from using payday loans may be to find some way to earn extra cash.  The purpose is to simply get ahead.  If that means working an extra job for a short period of time, then do it.  If it means borrowing money from friends and family with full intentions of paying them back, then do it.  Doing nothing other than paying more money in fees than you borrowed does not make financial sense. Two other solutions also come to mind. First, learn how to prepare for an emergency. Second, apply the teaching by Bob Proctor who instills the message, You Were Born Rich.  The answer might not be so simple but you must do something so that cash stores will not be the solution to put food on the table.       



Are You Prepared for Any Emergency?

Is saving the same as investing? It can be yet it depends on your intent.  Do you plan to spend this money in the next year or in retirement? Both actions appear the same. You tuck money away for a future event but what if something happens unexpectedly?  These unexpected and unwanted events are emergencies. The question is, “Are you prepared for them?

 

The Importance of Emergency Savings

By not having emergency savings, you are forced to rely on credit. When you borrow money to cover unexpected expenses, the loan has to be paid back. At times, it may be necessary to borrow. However, if you don’t qualify for credit, then you’re stuck.  This is not a “happy place” where anyone wants to be.  Another downside is even if you qualify for the loan, the interest rate may be ridiculously high.  Add interest to the cost of your unexpected event and the expense can be enormous.  Using credit as your initial back-up plan only works until you build up your emergency savings.

The Amount Needed for Emergency Savings

Generally, the minimum amount is three months of your monthly living expenses. However, a better safeguard is six months.  I often hear, “It’s a shame to let the money just sit there” yet it isn’t sitting there. The money is waiting for that emergency.

• The fridge crashes; now you need to shop for a new one.
• The encounter with the deer on highway left you stranded without a vehicle.
• The fall off the ladder created additional medical-related expenses.

The above emergencies appear minor in comparison to other tragedies.

• Being laid off from your job.
• An illness in the family which forces you or your spouse to take a leave of absence from work.
• An unexpected death in the family.

If you’ve never had an emergency, then you may know friends and family who had one. What have you learned from their episode? Were they scrambling to borrow money to cover their needs? Were they unable to get credit and forced to rely on extended family for financial help?

 

With so many reasons to save, start by determining your pots of gold.  Multiple pots are required because you have multiple intentions:  emergency savings, planned spending, yearly expenses (i.e. Christmas, insurance, property taxes); and then the elusive future savings for children’s education and retirement.  Our focus now is strictly on emergency savings. 

 

 

Two Methods to Save

1. If you are a disciplined saver, your emergency savings can be mingled with savings for other purposes in one account.  For example, once you establish the first $5,000, this amount is ear-marked as emergency savings.    Any savings above this is for other goals. Once you establish your threshold, the plan is to never spend any of this emergency amount for any other purpose than an emergency.

 

2. If you are a saver who likes separate accounts, money can kept in a daily savings account labeled as “Emergency Savings”.  The power is in the name. Before you tap into the account, ask yourself, “Is this truly an emergency?” 

  

Best Type of Accounts for Emergency Savings

You can keep your “emergency savings” in a daily savings account held either in a Tax Free Savings Account (TFSA) or an open (non-registered) daily interest-bearing account. Understanding the different types of investment accounts is important when you match them with your goals and time horizon. {This topic will be discussed at another time.}

It’s important to understand the value of your savings should not fluctuate.  When you save a dollar in this account, you want access to this dollar a week, a month or a year from now.  Wouldn’t it wonderful if the value could double? However, since the timing of your emergency is unknown, the plan is to stick with the safe and sure path. The “tiny-bit” of interest earned in a daily savings account or money market fund is reassurance your money will be there when you need it.  Explain to your investment advisor that your principal investment needs to be protected in case of an emergency. “Nothing fancy, please!”

How to Save

To build your emergency savings, you must first determine how much you need to save.  Start by adding your monthly expenses (everything) and then multiply this amount by six to ensure you cover six months’ worth of expenses. Begin tucking money away. Use every method possible to build your emergency savings.

• Set-up automatic transfers for a specific amount to coincide weekly, bi-weekly, or monthly with your pay periods.
• Transfer excess earnings above your regular pay from bonuses or over-time.
• Deposit money earned from different money-earning activities. For example, playing in a band, cutting grass, and writing free-lance articles.
• Save the money reimbursed for medical expenses covered by your health care.
• Save the money reimbursed for employment-related expenses, for example, mileage.  
• Deposit your tax refund in your emergency savings.

Acceptable to Start Again  
 
Give yourself permission to start over if you slip-up. Forgive yourself. We learn from our mistakes.  Tell yourself,

“The next time I will do better.” 

 “The next time I will stop myself.”

“The next time I will walk away.” 

You are striving to create security for your family and you. Once you catch the fever of savings, you will experience empowerment. Then regardless of the emergency, you will be prepared for it.