Need a loan this Xmas? Whether you pledge your paycheck, tap your home equity or pawn your toaster, you need to be careful. Loans are not at all the same, and some can create more financial problems than the one you want to solve. Here are five types of loans and the dangers that they can pose. Payday loans: How's 400% interest sound?
Payday loans, also known as a deferred deposit service, are loans issued against a paycheck. These are small, short-term loans that typically range from $100 to $500.
To get one, you write a postdated check for the amount desired, plus a fee. The check casher or payday lender holds the check until you get paid. The typical loan period is two weeks. On payday, you take cash to the lender and exchange it for your postdated check, or you allow the lender to deposit the check. If you do not show up with cash, the lender cashes the check.
If you cannot pay back the loan at the end of the two-week period, expensive problems begin.
If you ask the lender to hold the loan for another pay period, you pay the fee a second time and the loan rolls over. If you are charged a $20 finance charge on $100, your annual percentage rate is 521%.
For many borrowers, this type of loan creates a vicious and costly circle. "Once they've got you hooked, it's really hard to stop," says Jean Ann Fox, director of consumer protection for the Consumer Federation of America in Washington, D.C.
Payday lending laws vary from state to state. Some companies have gotten around restrictive state laws by teaming up with national banks that operate under the laws of a different state.
"Currently, 35 states allow payday lending," says Sharon Reuss, communications associate of the Center for Responsible Lending, a unit of community-development lender Center for Community Self-Help. "In spring 2004, Georgia enacted a strong law that outlaws triple-digit payday lending. We consider it the strictest."
According to the center, a typical borrower of payday loans pays $15 for every $100 borrowed in a two-week loan. That ends up being about a 400% annual percentage rate.
"Payday loans are predatory by design, because fees from repeat borrowers are the lifeblood of the business," says Reuss.
In 2003, payday lenders serviced between 10 million and 12 million customers. Nearly 40% of the borrowers have an annual household income level of $25,000 to $50,000, and 34% are homeowners. Borrowers must have a job and a checking account to get one of these loans.
Before you consider this option, the Federal Trade Commission recommends that you compare the loan fees, interest rate and other costs, of payday loans to other credit offers. Under the Truth in Lending Act, the cost of payday loans must be disclosed.
A quick, and costly, visit to the pawnshop
Pawnshop loans carry terms of one to four months and are secured by a piece of property. Interest rates range in different states from 2% to 25% per month. Loan periods range from 30 days to 90 days, also depending on the state. Almost all states require pawnbrokers to allow a grace period, says Bob Benedict, executive director of the Dallas-based National Pawnbrokers Association. The collateral is sold if the interest or loan amount isn't paid in the specified period.
"Pawn loans are designed as small, short-term, quick-fix, quick-emergency cash, quick-help personal loans that the banking industry is not willing to serve because of the small amounts involved and the cost with servicing such a loan customer," Benedict says.
He says that, nationwide, the average loan is for $75 to $85, and on average, 80% of borrowers eventually get their items back.
Betting your car's title
Title loans are secured by your car's title. The lender determines how much you can borrow, based on your car's value. Typically car title loans range from $250 to $1,000, but can go as high as $10,000. The duration of these loans is most often 30 days. If you fail to make loan payments -- maybe just one -- the lender can repossess the vehicle.
The allowable interest rate varies from state to state. For example, the Florida Attorney General's office explains that Florida law allows a title lender to charge a fee of as much as 30% per year for the first $2,000 borrowed; 24% per year for any amount borrowed between $2,000 and $3,000; and 18% on any amount borrowed above $3,000.
"Car title pawns are really legalized car theft, because you lose the entire car equity no matter what the loan amount is," Fox says. "To put all of that at risk to borrow a few hundred dollars is just not fair."
Upside down on your house
A high LTV home-equity loan is a loan secured by the equity in your home, but one that obliges you to pay more than your equity is worth. Some home-equity lenders allow you to create a loan-to-value ratio of as much as 125%.
Getting a loan for more than your property is worth can be a gamble. Houses rarely sell for more than their fair market value. The interest rates on 125% loans are usually higher than lower risk, regular home-equity loans, too, says Gerri Detweiler of Sarasota, Fla., author of "Slash Your Debt: Save Money and Secure Your Future." Also, all of the interest paid on the loan may not be tax deductible.
"To be upside down on your house and to move is really frightening," Detweiler says. Homeowners seldom think about all the things that can happen: divorce, a relocation or being forced to move before there is any equity in the home.
Not a loan, but a chance at one
Advance-fee loans are those in which a company accepts a fee in exchange for a promise to find a lender who will make a loan or issue another type of credit. These companies claim a high success rate, even with borrowers with a tainted credit history. If you pay the fee before checking into the lender and the offer, you risk getting taken.
The FTC says legitimate lenders may require consumers to pay application, appraisal or credit report fees, but these fees are never required before the lender is identified and the application completed.
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