Bad credit history? You can opt for a payday loan but read this first

They are banned in 15 states in the US, China has capped the interest they can charge and consumer groups in European countries are fighting to get them banned. But in India, payday loans are flourishing unchecked, with more than a dozen lenders having started operations in the past two years.

A payday loan is an ultra short-term borrowing meant to help the individual tide over a temporary crunch. Think of it as a personal loan for 7-30 days which has to be paid in full along with interest when you get your next salary. An estimated Rs 400 crore is disbursed by payday loan companies every month.
However, these loans are prohibitively costly, charging an interest between 1% and 1.5% per day. On an annualised basis, this works out to 365-540%. Credit cards, which charge 2-3% per month for rollover (or 24-36% per annum) appear cheap in comparison.

The upside is that payday loan companies are not as finicky as traditional channels of credit. They don’t mind sullied credit histories or low credit scores. In fact, it helps them charge high rates. Payday borrowers are typically subprime customers who desperately need cash but have exhausted all other options. Banks won’t give them personal loans at 15-20% due to their poor repayment record. They can’t withdraw using their credit cards because they may have already hit the limit.

Minimum paperwork required
Speed of disbursement is critical in such loans. Payday loans require minimum documentation and are disbursed quickly. A borrower just has to upload a few documents (Aadhaar, PAN card, latest salary slip and 3-month bank statement) and hand over a post-dated cheque of the amount payable at the end of the tenure. The post-dated cheque is the security the lender needs. If it bounces, the issuer can be prosecuted under the Negotiable Instruments Act.

Payday loan companies and charges
Interest of 1% per day works out to 365% on an annualised basis.

Source: Company websites

The ease of access to credit may seem like a boon, but payday loans seldom solve the problem faced by the borrower. According to Consumer Finance Protection Bureau of the US government, over 80% of payday loans are rolled over or followed by another loan within 14 days. One out of two borrowers end up taking at least 10 more loans before they are debt-free. In many cases, the borrower only digs himself a bigger hole. This is why payday loans have been banned in most US states and are under the scanner in other countries. In China, the maximum interest that can be charged on payday loans is 36%.

“The RBI should place a cap on how much a lender can charge. An interest of 1% per day is terribly usurious,” says Raj Khosla, Managing Director, MyMoneyMantra.

The high interest rate is not the only cost for the borrower. There is also a processing fee that can be as high as 7% of the loan amount. If the cheque bounces or you want to extend the repayment date, you are slapped with penal charges of Rs 500-1,000.

Payday loan or advance?
The need for cash has spawned an industry for short-term loans. And not all lenders charge a bomb. Earlysalary.com CEO and co-founder Akshay Mehrotra draws a distinction between his company and payday lenders. “We are not a payday loan company but a salary advance company,” he says. “Our objective is to help the borrower manage his cash flow by giving him a loan he can repay in three monthly instalments.”

For borrowers, the difference is the rate of interest charged. Earlysalary gives loans of up to 50% of the salary and charges 2-2.5% per month. Think of it as rolling over your credit card balance for three months. Earlysalary disburses loans worth `150 crore every month.

To be fair, even payday loan companies are not exactly loan sharks trying to lure borrowers into an endless cycle of repayments and borrowings. Some of them warn borrowers upfront about the high costs of the loans they offer. Loanwalle charges 1% per day on the loan, but discourages repeat borrowers by hiking to rate by 1 bps everytime a borrower comes back for more. “One should take these loans only for emergencies. An emergency can’t come up every month. If you take these loans repeatedly, very soon you’ll go bust,” says Abhijit Banerjee, Director of Loanwalle.