If you’re in a tough 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 do 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, also called a FICO score, is a 0-850 that reflects how creditworthy you are.
Credit scores are calculated by a handful of different credit bureaus on the basis of data that the bureaus gather about consumers. The big credit bureaus are Experian, Transunion, and Equifax, but in payday world you also have Factor Trust and Clarity.
Nobody knows exactly how credit scores are calculated, 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- The balance of funds withdrawn from each credit line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
Not all these factors have equal weight. For most consumers, the utilization rate of the maximum available credit line is the largest factor influencing a credit score. If the utilization rate is under 30%, and the consumer regularly pays their debt before it is due, their credit score will rise.
In contrast, if the utilization rate is higher than 30% or approaching 100%, the consumer’s credit score will trend towards lower numbers. Similarly, carrying a large balance on a credit line is detrimental to the credit score.
The age of each line of credit is also highly relevant in the long-term for a person’s credit score. The older each credit line gets, the more it helps your credit score.
For more info on how credit scores are calculated, see this video by the Federal Reserve Bank of St Louis.
It’s a common misperception that credit score algorithms are a “black-box” that nobody truly understands except for the Data Scientists working under the Credit Bureaus. In reality, this is far from the truth. For an additional in-depth breakdown of 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
Among these types of financial instruments, each is weighted differently when the credit score is calculated. Student loans and mortgages are typically under-weighted, whereas credit cards carry a standard weight.
Generally, the way that credit scores work is that a consumer first requests a line of credit. The lender of that line of credit checks the consumer’s credit score by asking one of the credit bureaus.
The bureau then calculates the consumer’s score based on the factors described above, then reports it back to the lender. Next, the lender decides whether the consumer is creditworthy enough for the financial instrument which they can provide.
The key term to remember is “creditworthy enough.” Lenders expect that a percentage of the people they lend to will default on their loan and be incapable of repayment. While there are steps that lenders take to avoid losing money when consumers default, the main step they take is to calibrate the interest rate of their line of credit relative to the chance of the borrower defaulting.
If the borrower has a high chance of defaulting on the basis of their credit score, the lender will charge them a higher rate of interest or only allow them to use certain financial instruments which are inherently short-term, thereby reducing their risk.
In contrast, if a person’s credit score indicates that they are highly creditworthy, the lender can offer them lower interest rates, longer payment periods, and other benefits to compete for the consumer’s business.
As a rule of thumb, the less a consumer needs a given line of credit, the more generous the terms that consumers can get when they access new lines of credit. Similarly, the more desperate the consumer, the harsher the terms they’ll be forced to accept, assuming they can find a lender whatsoever.
Do payday loans affect your credit score?
Short answer: Most of the time, a payday loan will not show up your credit report from the major credit bureaus (Trans Union, Experian, and Equifax) if you pay it back on-time.
However, most lenders will report your loan to niche reporting agencies that are only used by payday lenders, namely Factor Trust and Clarity.
If you do not repay a payday loan, it is possible that you go into collections, which is likely to impact your credit score. If you pay your loan on-time, you shouldn’t have anything to worry about.
How Payday Loans Affect Credit
Importantly, payday loans can be accessed without a ding on a person’s credit report. Likewise, payday lenders often state that they will not report the loan to the credit bureaus. This means that if a person takes out a large payday loan, their credit score may not change at first, provided that the lender keeps their word.
Unfortunately, payday loans can still have a deceptively high impact on a person’s credit. Because payday loan borrowers frequently default on their debt, if the lenders didn’t ever report any of their defaults to the credit bureau, they might have an even harder time screening their potential borrowers.
Thus, when a person defaults on a payday loan and the lender judges that they can’t pay it back, the lender often sells the right to the debt to a collections agency. Collections agencies are distinct companies that are under no obligation to refrain from reporting the borrower’s default on the payday loan.
As a result, the lender remains true to their promise that they will not report the loan to a credit bureau, yet the consumer’s credit rating is damaged nonetheless, provided that they are in default. If a person isn’t in default on their payday loan, there are still reasons why payday loans are not the best idea when it comes to preserving or raising a credit score.
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, they are not obligated to report on-time payments of payday loans.
In other words, payday loans might present a large risk to a person’s credit score, but they can’t be used to build credit or repair damaged credit when they are paid on time.
Aside from the technical details surrounding custody of the payday loan’s debt, there are financial factors at play that are worth knowing regarding payday loans and credit scores.
While payday loans in and of themselves may not always damage a person’s credit score, the situations in which someone takes out a payday loan may well lead to it causing damage. If a person is taking out a payday loan, they may have already maxed out their other lines of credit.
However, they cannot legally use their payday loan to pay off debts from their other lines of credit, and, if they attempt to do so, the credit agencies may ding their credit score even further.
Using Payday Loans Without Harming Credit Scores
In theory, it is possible to use payday loans without causing any damage to a consumer’s credit score. For a consumer to use a payday loan without it harming their credit score, several conditions must be met.
First, the payday lender must explicitly state that they do not report their credit line to the major credit bureaus. This ensures that the credit bureaus will not register the additional line of credit.
Second, the payday lender must also explicitly state that they will not perform a hard check on the credit of the borrower. Hard checks cause damage to credit scores, but the damage is typically minor.
Finally, the consumer must commit to paying off the payday loan in full by its due date. When consumers pay the loan off in full, the lenders have no grounds to send the loan to collections, thereby avoiding the prospect of a collections agency reporting that the consumer is delinquent on their loan debt.
If a consumer can reliably meet the above criteria, they’d probably be better served by a credit card rather than a payday loan, however.
Repairing Credit After Payday Loan Damage
When a consumer’s credit has been damaged by having their payday loan defaults reported to a collections agency, there are a few steps that can make the difference between sustained damage and a short-term blip.
First, ensure that the collections agency is only operating within the boundary of what is legally mandated. Consumers are equipped with a handful of protections against payday lenders and collections agencies. Many consumers don’t know their rights, however. Many collections agencies employ shady tactics that skirt the law, and they are enabled to do so by their close collaborations with payday loan lenders.
Next, stop taking out payday loans as soon as possible. While each individual payday loan may not harm a credit score, the aggregate of the loans will probably be detected by a credit agency as a result of maxing out the other credit lines.
Finally, once a consumer is no longer taking out payday loans, the most important thing is to remain current with all of their outstanding debt payments. Remaining current prevents loans from falling into default, which prevents subsequent damage to the consumer’s credit score.
If necessary, there are also a handful of resources that consumers can access to help repair their credit scores. These resources include refinancing and legal aid intended to help consumers reduce the burden of collections activities.