How Does Renewing a Loan Work?

Borrowing money may provide much-needed cash to make a major purchase or meet other debt obligations, but it also obligates you to repay the loan in the future, regardless of whether your financial situation improves. Payday loans, which some states allow private lenders to offer based on borrowers' future income; sometimes feature an option for renewal, which can pose additional problems.

Payday Loan Basics

The process of renewing a loan refers to taking out a payday loan and allowing it to renew once it reaches its final due date -- and still has an outstanding balance. Payday loans rely on your future income to pay back your debt. They generally charge very high interest rates and require repayment within several weeks. Some states do not allow payday loans, while other states do but impose regulations on how much lenders can charge and how the renewal process works.

Automatic Renewal

Some states allow payday lenders to automatically renew loans not paid in full by their due dates. This automatic form of renewal can cause problems for borrowers because, despite giving more time for repayment, it also resets the interest rate based on the existing balance, which includes interest and origination fees from the previous loan period. Automatic renewal creates compound interest, which is interest on top of old interest, driving up the borrower's balance and making the loan more difficult to repay over time.

Regulations

Each state that allows payday loans has its own policy on loan renewal. Some allow unlimited renewals, which is the most dangerous for borrowers. Others require borrowers to request renewals. Automatic and borrower-initiated renewals are subject to time limits, which include how many times a loan is renewable or how long a loan can continue to renew after its original issue date. Once a loan can no longer be renewed, the lender must pursue collection of the amount due.

Tips and Advice

In the states where they're available, payday loans are an option of last resort for borrowers. Other options, such as bank loans, personal loans from family and friends and paycheck advances from an employer, are all likely to be better options. If you do take out a payday loan, read the fine print carefully before signing the loan agreement. Take special note of the renewal policy and keep a copy of the loan agreement in case the lender violates state law. Pay back your loan as soon as possible, since renewal will cost you more and keep you in debt longer.

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