04/22/2014 05:54 EDT | Updated 06/22/2014 05:59 EDT

The Problem With Payday Loans

Cash Store Financial Services Inc. filed for bankruptcy protection on April 15, 2014. Court documents show they are losing $2 million per week, and have well over $100 million in debt.

I will start by stating my biases: I am not a fan of payday loans. I believe they are a very expensive form of borrowing, and in almost all cases the borrower has better options.

I've heard the sales pitch: rent is due tomorrow but payday is a week away, so get a payday loan now! It only costs $21 on $100! Twenty-one dollars on $100, on a two-week loan, averages out to an annual interest rate of well over 500 per cent! Do you really want to pay the loan back five times every year?

Obviously a better option would be to save money so you can pay your rent, but if you really are in a bind and have no family or friends who can help, would it not be better to talk to your landlord and ask for a few extra days to pay the rent?

In their court filings Cash Store says they serve "individuals for whom traditional banking may be inconvenient or unavailable."

All Canadian banks offer 24/7 on-line banking, and many banks are open evenings and weekends, with longer hours than the Cash Store, so I'm not convinced traditional banking is "inconvenient".

I read through the over 500 pages of court documents, and there was one sentence that really explained the issue, and offers a valuable lesson to all borrowers:

"Since Cash Store is unable to make new loans in Ontario, its ability to collect outstanding customer accounts receivable has also been significantly impaired."

In other words, The Cash Store is having the same cash flow problems as the clients they purport to help. With no new cash coming in, they can't pay the bills. For The Cash Store however they have a double problem:

  1. No new loans means no new interest and fee income
  2. No new loans means existing customers are not paying back their old loans.

The Cash Store's customers can only repay their loans if they can get a new loan to repay the old one! Now that the Ontario government has shut them down, they can't make new loans, so they can't collect the old ones.

Think of it like this: it's the equivalent of losing your job (future income) and having your bank account frozen (so you can't get at what you have).

Here's where I lose sympathy. My biggest problem with payday loans is that they create a vicious cycle. I borrow $500 today and have to pay back $600 next payday, but when I get paid I need money for food and rent. That means I can only pay back the first payday loan if I get a second one. It's easy to see where that cycle leads, as you must continually borrow from one payday loan to payback another.

In many cases the cycle only ends with bankruptcy.

Twelve per cent of people who go bankrupt owe money on a payday loan, and when they go bankrupt they have, an average, not just one but three loans outstanding. Worse, they owe in total almost $2,500 on payday loans which is almost an entire paycheque.

That's the problem: one payday loan leads to another. You can't stop at just one. Relying on credit to makes ends meet, just increases your dependence on credit.

The Cash Store is under bankruptcy protection primarily because the Ontario government broke the cycle of borrowers repeatedly borrowing to pay back previous loans, by not allowing the Cash Store to make new loans.

I started by saying I'm not a fan of payday loans, so perhaps I am being overly harsh. Are payday lenders the only lenders that encourage this vicious cycle?

Probably not.

Ask yourself this question: have you ever used a cash advance on a credit card to make your payment on another credit card? Have you ever used your line of credit to pay your mortgage or car loan?

It's not just payday lenders that rely on borrowing from Peter to pay Paul. All banks encourage the same practice. That's why banks don't mind that you already have one or two credit cards when you apply for a third one with them. They understand the game.

Unfortunately for you, the cost of playing this game is a lot of interest payments, so the lesson is obvious: only borrow if you have the cash flow to repay the loan without the need to continue to borrow.

Stop the vicious cycle, and keep your money in your pocket (unless you really want the bankers to have it).