If you’re in a tight spot financially, you might turn to payday loans to help cover expenses in the short term.
As with most loans, payday loans do have implications on your credit scores, which can impact your ability to get loans — payday and other types — in the future.
Payday loans can and will affect your credit score. In this post, we’ll dive into the details and nuances of how this all works.
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How are Credit Scores Calculated?
A credit score, which might also be called a FICO score, ranges from 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.
Nobody knows the exact algorithm used to determine credit scores, but they use a combination of the following data points:
- The number of credit lines
- The age of each credit line
- The value of each credit line
- The balance of funds withdrawn from each credit line
- The utilization rate of the maximum available credit
- The history of on-time payments
- The number of credit checks
- The income of the consumer
It would be awesome if each of these criteria carried the same weight. Unfortunately, some criteria “weigh” more than others.
For example, the ratio of used/available total credit often carries the most weight in calculating a person’s score. Payment history also carries a lot of weight.
Therefore, if a person limits their credit usage to less than 30% of the credit allocated to them, and always makes their payments on time — or, even better, early — that person’s score will likely go up.
On the other hand, if a person has used nearly all of the credit they have available to them, their score will likely drop. Allowing balances to remain high for an extended period can also negatively affect a score.
It’s also true that the age of a line of credit is an important factor in someone’s credit score. The older the line of credit, the better that person looks to potential lenders, etc.
Confused? It’s OK. Watch this video by the Federal Reserve Bank of St Louis for an in-depth breakdown of how credit scores are calculated:
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:
- Payday loans
- Bank loans
- Credit cards
- Student loans
Like the different criteria mentioned in the previous section, each of these loans/lines of credit carries slightly different weights on credit score. For example, long-term loans like student loans and mortgages carry relatively little weight, while credit cards carry a “standard” amount of weight.
Typically, Credit Scores Work Like This:
Let’s say you want to apply for a line of credit with your bank. Your bank will then contact one of the three credit reporting bureaus to check out your credit score and credit report.
The credit bureau takes all the data points that it has on you (the criteria mentioned above) and plugs them into their algorithm to get a number, which they report back to the bank.
The bank takes that number and the data points on your credit report and uses them to determine if your credit is “worthy” enough for the line of credit you want.
Do Payday Loans Affect Your Credit Score?
Short answer: Most of the time, a payday loan will not show up in a credit report from the major credit bureaus (TransUnion, Experian and Equifax) if you pay it back on time.
However, many lenders will report your loan to niche reporting agencies that are only used by payday lenders such as FactorTrust and Clarity.
Unfortunately, if you don’t repay a payday loan, it may go into collections, which will likely impact your credit score. If you pay your loan on time, you shouldn’t have anything to worry about.
Why Does “Creditworthiness” Matter?
Banks, credit unions and other lenders and creditors assume that a percentage of the people they fund will default on their payments and not fully repay their debts. To try to lessen that risk and ensure they recoup as much of their initial loan as possible, banks charge interest on the loans and credit lines they extend.
That interest rate is usually determined by a person’s “creditworthiness.”
If a person’s creditworthiness is high, they will be offered a lower interest rate on their payments. The person will also usually be given the option to lengthen the amount of time they have to repay the debt.
On the other hand, if a person’s creditworthiness is low, they will be charged a higher interest rate. The bank may also only allow them access to small loans with short repayment periods.
Basically, the less you need the money, the more money — and the better terms — you are likely to be offered.
This is why payday loans are scary.
What is a Payday Loan?
Payday loans let you borrow money against your own income, and you pay it back on your next payday. You’ve likely heard them called by another name: cash advances.
They’re a special type of personal loan that usually runs until your next paycheck. It is a short-term unsecured loan that requires no credit check or collateral.
Payday loans can range from about $100 to $500. Anyone with a steady paycheck or Social Security payment can qualify. But borrowers will pay shockingly high interest rates and processing fees. In most cases, borrowers will pay $18 to process a $100 loan, and the loans generally have APRs of up to 459% or even more.
How Do Payday Loans Affect Credit?
Many payday lenders promise to keep the major credit bureaus in the dark about your loan, provided you pay it back on time and according to the terms of your agreement. If you do this, the lender will likely keep their word, and your credit won’t be affected.
As we mentioned earlier, however, if you default on your payments then you void your contract. This means that the lender is free to send your account to collections and notify the bureaus of your delinquency (which the collections agency will likely do, too). If this happens, your credit score will drop.
Because collections agencies are distinct companies, they’re under no obligation to keep from reporting the borrower’s default on the payday loan. As a result, the lender keeps the promise that they won’t report the loan to a credit bureau, but the borrower’s credit rating is damaged nonetheless.
And while credit card companies and bank loans are obligated to report a consumer’s on-time payments when they take out a line of credit, payday lenders are not obligated to report on-time payments.
Even if a person doesn’t default on a payday loan, there are still plenty of reasons why payday loans are not the best idea. Because of the quick repayment time frame, no matter how optimistic borrowers might be about on-time repayment, life happens and many end up falling behind, taking out more loans and triggering more fees. It’s best to only consider payday loans as a last resort.
Using Payday Loans Without Harming Credit Scores
The easiest way to keep a payday loan from hurting your score is to only take out a loan when you’re absolutely certain you can pay back the loan — and any associated charges/fees — on time and in full.
If something happens and you find that you can’t make the full payment on time, contact the lender ASAP. Most lenders have plans in place for borrowers who run into problems during repayment. They may be able to extend the repayment period or work out some other arrangement with you. Of course, they will likely charge you fees for this privilege, so tread carefully!
What if the worst-case scenario happens and you default on your payday loan? Are you doomed? Not necessarily!
Repairing Credit After Payday Loan Damage
The good thing about your credit score and your report is that they can and will change. This means that, if you run into a rough patch with your payday loan, there are steps you can take to alleviate the damage. Here are a few of the steps you can take right away:
Stop Taking Out Payday Loans
It might surprise you, but people really do take out a second payday loan (from a different company) to pay off their first payday loan. Do not do this. All it does is trap you in a cycle of debt until you eventually end up defaulting 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. It is even better to stay current in the first place. That said, things happen. Be honest with your lenders.
Take These Steps Suggested by FICO to Improve Your Credit Scores
FICO, which stands for Fair Isaac Corporation, is a data analytics company based in San Jose, Calif., that focuses on credit scoring services. It provides a great list of credit repair steps that every consumer should follow to ensure their credit score is as high as possible. Here are some of the best tips on their list:
- Check credit reports and look for errors and fix any mistakes.
- Pay all bills on time.
- Refinance or consolidate your debt.
- Don’t open any new credit card accounts.
- Lower your credit utilization rate by using your existing credit responsibly.
- Hire a credit repair company.
- Use a credit builder loan.
- Start with a secured credit card to build credit (and make sure to make payments on time).
- Be aware that closing an account won’t make it go away: It will show up on your credit report and may impact your credit score.
Be proactive. Every consumer is entitled to free copies of all three credit reports through annualcreditreport.com. Review them yearly to make sure that all creditor and loan information is accurate. Keep an eye out for any payments that might be erroneously marked late. One late payment can remain on your credit report for up to seven years and decrease your score by as much as 100 points. Some websites will try to charge you for your reports. Don’t pay them.
In addition, there are a few other tricks to help boost your score. A debt consolidation loan could be a good option if you can qualify. It rolls all of your debts into one loan with a fixed monthly payment and a lower interest rate. This helps simplify your finances, helps with budgeting and could potentially cost you less in late fees, since there are fewer bills to keep track of. Your state might also offer some options for free or reduced-fee legal aid if you run into trouble with a debt collector.
The Bottom Line
Your credit score and credit report are important. They serve, basically, as the adult equivalent to a permanent record. Use the information shared here to help keep yourself on track to the highest score possible.