Payday loans are one option you may consider if you find yourself short on cash and need assistance with short-term expenses.
Payday loans do affect your credit scores, as they do with most loans, which may limit your future ability to obtain loans of any kind, including payday loans.
Payday loans can and will affect your credit score. We’ll delve into the specifics and nuances of how this all functions in this post.
How are Credit Scores Calculated?
The range of a credit score, also known as a FICO score, is 0-850. It reflects how creditworthy you are.
Credit scores are calculated by a handful of different credit bureaus based on data that the bureaus gather about consumers. The three major credit bureaus are Experian, TransUnion and Equifax, but in the payday lending world, you also have FactorTrust and Clarity.
The exact formula used to calculate credit scores is unknown, but it combines the following information:
It would be fantastic if all of these factors were equally important. Unfortunately, some criteria “weigh” more than others.
For instance, when determining a person’s score, the ratio of total credit available to used is frequently given the most consideration. Payment history also carries a lot of weight.
As a result, a person’s credit score will probably improve if they keep their credit usage to less than 30% of the credit that has been given to them and always make their payments on time, if not early.
On the other hand, a person’s score will probably decline if they have nearly used up all of their available credit. A score may suffer if balances are allowed to remain high for an extended period of time.
It’s also accurate to say that a line of credit’s age affects a person’s credit score significantly. In the eyes of potential lenders, etc., the older the credit line, the better that person appears.
Confused? It’s OK. For a thorough explanation of the methodology used to determine credit scores, view the following video from the Federal Reserve Bank of St. Louis:
For additional information on factors that may hurt or negatively affect your credit score, please see this post by Money Crashers.
What Types of Loans Impact Your Credit Score?
The following financial instruments can affect credit scores:
Each of these loans or lines of credit carries a slightly different weight on credit score, similar to the various criteria mentioned in the preceding section. For instance, credit cards have a “standard” amount of weight, whereas long-term loans like mortgages and student loans carry relatively little weight.
Typically, Credit Scores Work Like This:
Consider that you want to request a credit line from your bank. Your bank will then check your credit score and credit report by contacting one of the three credit reporting agencies.
The credit bureau enters all the information it has on you (the above-mentioned criteria) into its algorithm to generate a number, which they then relay to the bank.
The bank uses that figure along with the information on your credit report to determine whether or not you have “worthy” credit for the line of credit you want.
Do Payday Loans Affect Your Credit Score?
Short answer: If you repay a payday loan on time, it usually won’t appear on your credit report from the three main credit bureaus (TransUnion, Experian, and Equifax).
Nevertheless, a lot of lenders will report your loan to specialized reporting organizations used only by payday lenders, like FactorTrust and Clarity.
Unfortunately, you risk having a payday loan go into collections if you don’t pay it back, which will probably lower your credit score. If you repay your loan on time, you shouldn’t experience any problems.
Why Does “Creditworthiness” Matter?
The assumption made by banks, credit unions, and other lenders and creditors is that a portion of the people they finance will miss payments and/or fail to fully repay their debts. Banks charge interest on the loans and credit lines they extend in an effort to mitigate that risk and make sure they recoup as much of their initial loan as possible.
That interest rate is usually determined by a person’s “creditworthiness.”
A person with excellent credit will be given a lower interest rate on their payments. In most cases, the debtor will also have the option to extend the deadline for repayment.
On the other hand, a person will pay a higher interest rate if their creditworthiness is poor. Additionally, the bank might limit their access to loans to small amounts and short repayment terms.
Basically, you will be offered more money and better terms the less desperate you are for the money.
This is why payday loans are scary.
What is a Payday Loan?
You can borrow money from payday loans using your own income, and you must repay it on your following paycheck. You’ve likely heard them called by another name: cash advances.
They are a particular kind of personal loan that typically lasts until your subsequent paycheck. It is a brief unsecured loan that doesn’t require a credit check or security.
Payday loans can range from about $100 to $500. Anyone receiving a regular paycheck or Social Security benefit is eligible. However, borrowers must pay processing costs and shockingly high interest rates. Typically, borrowers must pay $18 to process a $100 loan, and the APR on these loans can reach 459% or higher.
How Do Payday Loans Affect Credit?
If you repay your loan on time and in accordance with the terms of your agreement, a lot of payday lenders guarantee to keep the major credit bureaus in the dark about your loan. The lender will probably keep their promise if you do this, and your credit won’t be impacted.
However, as we previously stated, if you fall behind on your payments, your contract is void. Accordingly, the lender is free to send your account to collections and notify the relevant bureaus of your delinquency (something the collections agency will probably also do). If this happens, your credit score will drop.
Collection agencies are not required to disclose the borrower’s payday loan default because they are separate legal entities. Because of this, even though the lender abides by their assurance that they won’t report the loan to a credit bureau, the borrower’s credit rating is still harmed.
And while payday lenders are not required to report on-time payments, credit card companies and banks are required to do so when a customer takes out a line of credit.
There are many reasons why payday loans are not a good idea, even if a borrower doesn’t default on the loan. No matter how confident borrowers are about timely repayment due to the short repayment period, life happens and many end up falling behind, taking out additional loans, and incurring additional fees. Payday loans should only be used as a last option.
Using Payday Loans Without Harming Credit Scores
The simplest way to prevent a payday loan from harming your credit is to never take out a loan unless you are absolutely certain you can repay it in full and on time, including any fees or charges that may be incurred.
Contact the lender right away if something happens that prevents you from making the full payment on time. For borrowers who experience difficulties during repayment, the majority of lenders have plans in place. They might be able to negotiate a different deal with you or extend the repayment period. Naturally, they’ll probably charge you a fee for this privilege, so proceed with caution!
Are you doomed if the worst happens and you can’t pay back your payday loan? Probably not!
Repairing Credit After Payday Loan Damage
Your credit score and report can and will change, which is a good thing. This means that there are steps you can take to minimize the harm if you experience difficulties with your payday loan. A few actions you can take right away are listed below:
Stop Taking Out Payday Loans
You might be surprised to learn that people do in fact obtain a second payday loan (from a different lender) in order to repay their initial loan. Do not do this. All it does is keep you stuck in a debt cycle, and eventually you default on both.
Make Sure Collections Agencies are Following the Law
The law requires collections agencies to follow very strict rules when contacting you about and trying to collect your debt. Many agencies will blatantly ignore these rules and resort to trying to frighten you into making a payment. The best way to protect yourself from their predatory ways is to learn your rights. The Consumer Financial Protection Bureau has basic collections laws so that you know what you do and don’t have to do. Each state’s laws are different, and in fact, payday loans are illegal in several states, so there could be some help there as well.
Know Your Own Rights
Consumers have a handful of protections that are designed to prevent payday lenders from preying on them. Learn everything you can about these protections so that you know which lenders are trustworthy and which aren’t. And, of course, report the lenders or debt collection agencies that break the rules. If you think your rights are being violated, start by reporting the lenders to the CFPB, Federal Trade Commission (FTC) and your state attorney general’s office.
Stay Current on Your Payments
It is better to renegotiate than to default. Being current in the first place is preferable. That said, things happen. Be honest with your lenders.
Take These Steps Suggested by FICO to Improve Your Credit Scores
Fair Isaac Corporation, also known as FICO, is a data analytics business with headquarters in San Jose, California. , that focuses on credit scoring services. Every consumer should follow the comprehensive list of credit repair steps it offers to make sure their credit score is as high as possible. Here are some of the best tips on their list:
Be proactive. Through annualcreditreport, every consumer is entitled to free copies of all three credit reports. com. Check them yearly to ensure that all loan and creditor information is correct. Watch out for any payments that may be mistakenly marked as late. One late payment can lower your score by up to 100 points and stay on your credit report for up to seven years. Some websites will try to charge you for your reports. Don’t pay them.
There are a few additional strategies to help you improve your score as well. If you can qualify, a debt consolidation loan might be a good choice. With a set monthly payment and a lower interest rate, it consolidates all of your debts into one loan. With fewer bills to keep track of, this simplifies your finances, aids in budgeting, and may save you money in late fees. If you have a legal issue involving a debt collector, your state may also provide you with options for free or reduced-cost legal aid.
Your credit score and credit report are important. They act essentially as an adult version of a permanent record. Use the knowledge presented here to help you stay on course for the highest score possible.
FAQ
Can a payday loan mess up your credit?
How Payday Loans Can Impact Your Credit. Payday loans are not listed on credit reports. Applying for a payday loan won’t appear on your credit report as a hard inquiry because payday lenders don’t typically check applicants’ credit, and they won’t let the credit reporting agencies know if they approve you.
What is the major downside of a payday loan?
Payday Loans Are Very Expensive – While high interest credit cards may charge borrowers an annual percentage rate (APR) of 28 to 36%, the typical APR for a payday loan is typically 398%. Payday loans are a financial quagmire because so many borrowers are unable to pay back the loan in the customary two-week time frame.
How long does payday loans stay on your credit?
However, payday lenders keep records, just like any lender, so missed payments on payday loans will show up on your credit report for six years. And this default gets reported and affects your credit score. Defaulting on a payday loan if your credit is already less than ideal could harm your credit history for several years.
Are payday loans a good idea?
In general, it’s best to stay away from payday loans and their exorbitant APRs. Many payday lenders request access to your bank account and take payments even if they would cause an overdraft. Furthermore, short repayment terms and high fees can keep you in a cycle of debt.