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Avoid the loan sharks

December 4, 2006 - Alexandria, Virginia

The availability of credit depends a lot on your particular financial circumstances. For those who own a home, there are plenty of ways to get home equity financing at rates that are relatively close to the current prime rate of 8.25%. Even if you don't own a home, standard rates on auto loans are generally less than 10%. If you have good credit and shop carefully, you can find platinum credit cards from banks like Fifth Third and Capital One with single-digit interest rates.

Yet for those with less-than-perfect credit histories, there's a scary trend in personal finance these days. In the past, people with a record of bad credit had trouble obtaining new credit at all. Now, however, it seems that nearly anyone can get credit; the only question is at what price. In the name of convenience, some borrowers are digging themselves into a hole from which they may never emerge.

Small money, big rates

You may have seen commercials on television offering unsecured loans to anyone needing money. These ads tend to focus on two things: how much money you can get, and how quickly you can get it. Lost in the fine print is the important information, including the interest rate and repayment schedule for the loan.

If you look at the websites for these lenders, it's often difficult to find this information at all. However, at least one website is brutally honest with its borrowers about the terms of their loans. The details are frightening. On a $2,600 loan, this lender charges an interest rate of 96%. Spread out over 42 monthly payments of $216.55, that comes to a total of more than $9,000 in repayments, more than three times what you borrowed, on a loan with a term of less than four years. If you're lucky enough to qualify for a $5,000 loan, you might only have to pay 59% interest, in 84 payments of $254.03 for a total of $21,338.52 over seven years.

Payday loans

Even more nefarious are so-called payday loans, in which borrowers receive small amounts of money from lenders on an extremely short-term basis to be repaid when they receive their next paycheck. In exchange for obtaining the loan, borrowers often must pay substantial fees to the lender. On a typical loan of $300, you might pay a fee of between $30 and $50.

On the surface, that may not sound so bad. However, when you run the numbers, those fees add up. Even if you only use a payday loan once, a $45 fee on a $300 loan is equivalent to paying 15% interest to borrow money for as little as a couple of weeks. Unfortunately, many borrowers are unable to repay their payday loans immediately, in which case the lender charges an additional fee each time it extends the due date until the next payday. Over the course of a year, you might pay that $45 fee 26 times for a total amount of $1,170 -- and still have done absolutely nothing to repay the $300 you initially borrowed. With an effective annual interest rate of 390%, it's pretty clear that payday loans are the quick road to the poorhouse.

What happened to usury laws?

Most states have laws that regulate the maximum interest rate that most lenders can charge on a loan. These laws, known as usury laws, vary from state to state, with some states having single-digit maximums while others have no maximums at all.

In the past, when interstate transactions were more difficult for consumers to make, these state laws did a fairly good job of controlling loan activity for their residents. Now, however, it's a trivial matter for consumers to go beyond the borders of their state to obtain financing. In response, many credit card companies and other lenders have chosen to operate from states without usury laws, including South Dakota and Delaware. Because the consumer voluntarily borrows from the organization, the laws of the lender's home state apply, and so the lender doesn't have to worry about the usury laws of the borrower's home state.

Making a profit

Lenders who make these high-interest loans defend their practices in several ways. For many borrowers, such lenders represent the only potential source of credit. Given the high risks involved in lending to borrowers with negative credit histories, default rates are extremely high, and so the high rates of interest charged to people who actually make payments help to offset the losses from bad loans. Furthermore, lenders argue that it takes just as much time to approve a small loan as a large one, so they point to similar fees charged by other financial institutions for large loans like mortgages and home equity loans.

For investors, subprime lenders can provide a roller-coaster ride. For instance, shares of Providian fell dramatically in 2001 surrounding class-action lawsuits and allegations of improper marketing of loans, but then rose just as impressively before the company was acquired by Washington Mutual(NYSE: WM) in 2005. When borrowers are able to make big interest payments, these lenders can make a lot of money. But when the economy starts to go south and borrower cash flow gets pinched, subprime lenders find themselves on the front lines of payment defaults.

On the personal finance side, the best way to avoid these lenders is never to find yourself in a situation where you have to resort to borrowing from them. Building and keeping an emergency fund with enough money to cover a few months of expenses provides a strong line of defense in the event of financial difficulty and gives you a cushion to consider future options more rationally. The last thing you want is to find yourself with a debt you may never be able to repay.

News Source

The Motley Fool, Dan Caplinger, Staff Writer

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