Small dollar credit is a term often used to describe some of alternative methods of borrowing money, especially if you’ve got poor credit scores. Many times the lack of competitive options from mainstream lenders forces people to turn to second tier loan options when emergencies arise. However, while these alternative loans may seem like a solution to a short-term financial problem, in reality they can quickly turn into a debt disaster.
Payday loans are short-term loans with very high interest rates for relatively small dollar amounts. The reason these loans often seem attractive to consumers who do not have a relationship with a mainstream lender (i.e. a credit card issuer or traditional bank) is because payday loans are usually easy to get and do not require a credit check during the application process. A recent study reported that 12 million people borrowed nearly $50 billion dollars through the use of payday loans in 2013 alone.
How It Works
The payday lender gives the borrower a loan for a small amount; let’s say $200 for example. The borrower writes the lender a check for the full loan amount plus the fee charged for borrowing the funds; let’s say $30. The lender agrees to hold the borrowers check until the loan is due, typically on the borrower’s next payday.
When the loan comes due the lender will either cash the check or the borrower may have the option to roll the loan over. If the loan is rolled over until the borrower’s next pay period then another fee ($30 in our example) is assessed. If a borrower rolled over the $200 loan in our example 3 times then she could easily pay $90 in fees for borrowing a mere $200.
Like Payday loans, pawn loans (as in “pawn shop”) are also among the most expensive types of loans available. Selling an item to a pawn shop or borrowing money against an item with a pawn dealer is certainly not the best way to get a competitive deal.
How It Works
The consumer enters a pawn shop and asks the pawn dealer, “How much will you loan me for my [insert item here].” The consumer is in fact borrowing money against some piece of property such as jewelry, firearms, computers, etc.
The pawn dealer will likely offer the consumer no more than 50% of the value of the item. That makes him fully secured, twice over, in case you don’t pay him back. No other lender has that type of security. If a pawn dealer loans a consumer $50 for her diamond ring then she will have to repay the $50 + interest to get the ring back. Interest rates vary but it’s not unheard of for them be above 100% when annualized.
At the end of the loan period the consumer can either (a) pay the full loan amount plus interest and fees to reclaim the ring (b) pay a fee to extend the loan for a longer period of time or (c) do nothing and the pawn shop will sell your ring and keep any profit. While pawn shops will never admit this, they’d rather you default on your loan and let them take ownership of the item so they can sell it. They make considerably more margin.
Title loans are short-term loans similar to payday loans. Typically car title loans are issued for a slightly larger amount than payday loans due to the fact that they are secured by using the borrower’s title to their car.
Consumers with poor credit or no credit are the usual customers of title loan companies due to the fact that the loans are easy to get and require only income verification, not a credit check. Interest rates on title loans are usually very high.
How It Works
In order to be eligible for a title loan you must own your vehicle free and clear. The title loan company will take the title to your vehicle plus a spare set of keys in order to secure the loans. Then the consumer will usually be loaned up to 50% of the car’s value, making them fully secured twice over like a pawn loan.
If a consumer were to put up her car which is valued at $2,000 for collateral then she would receive a loan for around $1,000. If at any point the borrower defaulted on her loan then the lender would simply pick up the car, sell it for likely much more than the amount owed on the debt, and pocket the profit.