Payday loans or cash advance loans are small, very short-term, unsecured loans approved on the basis of a quick review of the applicant’s recent pay history, employment confirmation and bank account information. Interest is charged in the form of a fee typically imposed for each $100 borrowed, in the range of $10-50. Borrowers repay the loan by issuing a check covering the borrowed amount plus the fee dated for the beginning of the next pay period or by the lender debiting the customer’s checking account for this amount for the next pay date.
The impact of a payday loan on borrowers’ credit score is a hotly debated topic. The available information is sharply contradicting and includes a lot of anecdotal ‘evidence’ and very little factual data points. Often opinions are presented without clearly qualifying the assumptions and actual scenarios resulting in broad and misleading generalizations. The fact is that the impact of payday loans on the customer’s credit score depends on a number of factors; some unique to the typical payday loan scenarios, while others more general for all types of loans..
Impact of a new loan on the credit score
The addition of a new loan to an individual’s credit history can affect the score for three different reasons.
The loan application process typically involves at least one or – in the case of rate shopping – more hard credit report inquiries. Hard credit report inquiries – inquiries made with the intention of establishing a new debt – typically have a negative impact on the credit score. Potential rejections of loan applications may also reduce the borrower’s estimated creditworthiness.
If a new loan is approved, the initial impact of the approval may be negative, especially if the result is a significant increase in the borrower’s total outstanding debt. For certain clients – customers with short credit histories or no or limited available credit – a new loan can have a slightly positive impact. Certain types of loans, such as a mortgage or a car loan, may also increase the score for consumers whose mix of debt did not include such, more ‘favored’ installment credit facilities before.
Eventually, the biggest impact comes from the borrower’s payment behavior: consistent payment on the new loan will – over time – have a positive impact, while late or missed payments or default will damage the borrower’s credit.
Impact of payday loans on credit score
Impact of inquiry and approval
As most payday loans involve no credit report check at all, cash advance borrowers can avoid the negative impact of inquiries associated with establishing a new credit account. The approval or rejection of a payday loan application will not register on the credit report. As payday loan businesses do not run credit checks, the initiation of the loan will not be visible at all.
Payday loan repayment’s impact on the credit score
If payday loan businesses report the loan to the credit bureaus – which some do as a routine process, while others offer borrowers a choice on whether or not to provide the credit agencies with information on the debt – the report will typically come at a time when the borrower’s performance regarding the payment obligation is already known due to the very short, no more than 30 day term of these loans.
By this time, borrowers may have repaid the loan or may have defaulted on their obligation.
Default will undoubtedly have a negative impact whose extent depends on the borrower’s prior standing and history.
Repayment of the loan may or may not provide a boost to the credit score. If the borrower repays the loan without incurring additional debt – for example without rolling the payday loan over into a new one – he or she may register a small increase in the credit score. The impact will, however, be limited for a number of reasons. These loans are small, typically not exceeding $500. As they were not reported at inception, the boost that borrower’s experience when they pay off an existing loan captured in their reports and thus lowering their debt balance that has been visible to the credit bureau is not there for payday loans. Finally, credit bureaus reward borrowers with the most generous score improvements for consistent patterns of timely debt payment. No such pattern can be established with a 14-day cash advance loan.
Nevertheless, repaid payday loans can provide some score increase, especially for borrowers with significantly compromised credits. There are some assertions, not backed up by data, that borrowers with higher scores may see no benefit or even some damage from repaid payday loans as such sub-prime debts may be considered negatively for consumes with good credit.
Borrowers rolling over the payday loan with penalties and higher fees could see damage to their credit scores. The extent of the deterioration is a function of an increase of the outstanding debt balance and potential late and missed payments. Long-term and continuous roll-over of cash advance loans typically results in an eventual default with an unavoidable hit to the borrower’s credit.
Potential indirect impact
While the repayment of a payday loan may have a small positive impact on the credit score and failure to pay results in almost certain credit deterioration similarly to default on any other type of debt, there could be other indirect ways that a payday loan could at least maintain the borrower’s existing level of creditworthiness. If the debtor uses the loan amount to repay an existing liability already recorded with the bureaus and potentially in danger of default or collection, he can at least temporarily rescue his score from deteriorating. If he can also honor the cash advance loan’s upcoming payment obligation, the overall impact of the loan will be beneficial, although it may not manifest itself in as actual score improvement.
Payday loans should not be used as a credit-building tool
Despite some cash advance providers’ marketing efforts highlighting the perceived benefits of payday loans in credit repair, borrowers would be best advised to use them exclusively as a last resort of borrowing in true emergency situations. Given the small size and the short duration of these loans, consumers would need to assume and repay such loans repeatedly for an extended period of time to see a meaningful boost to their credit rating. If they are in a financial and employment situation where they can confidently enter multiple consecutive payday loan transactions that carry a significant financing charge, they should have sufficient saving potential to accumulate a small amount of funds for a secured credit card application. Using a secure credit card for credit repair is a better and safer way for rebuilding credit than the extremely high-cost and potentially risky payday loan strategy.