How A Cash Advance Works
Wouldn't it be nice if you always had plenty of money to pay all of those pesky charges that come out of nowhere and blindside you? Unfortunately, cars break down, kids need money for a trip, and let's not forget about that root canal.
When those unexpected expenses show up, where does the money come from? Ideally, your emergency fund will provide the cash. If that's not an option, you might consider a cash advance.
How Cash Advances Work
A cash advance isn't a single type of loan but a category that includes payday loans, cash loans against your credit card and others. A payday loan is a short-term loan against your upcoming paycheck. The lender gives you cash; when you get paid, you pay back the loan. Local lenders and national franchises offer payday loans.
A cash advance against your credit card allows you to receive cash much like a normal credit card charge. Each card issuer has different rules and features. Some allow you to withdrawal cash from ATMs while others send blank checks.
The Problem with Cash Advances
No loan is completely customer friendly and cash advances are no exception. In fact, many have exceptionally high interest rates. If you're planning to use your credit card to borrow cash, you'll pay an average of 24.4% – about 6% higher than the interest rate charged on regular purchases. See The 4 Worst Reasons For a Cash Advance.
A payday loan is even higher. Paying $15 to borrow $100 may not seem outlandish, but because of the short loan duration that works out to an average annualized rate of more than 400%.
But why worry about the annualized rate if the loan only lasts about two weeks? Because the loan is almost always rolled over. According to a recent study by the Consumer Financial Protection Bureau (CFPB), 80% of all payday loans are rolled over with 14 days of the previous loan. In fact, most loans are renewed multiple times throughout the year. For more on these problems, read Beware of Payday Loans.
Cash advances against a credit card are less pricey, but seldom used. A 2013 study by the CFPB found that only 3.1% of active credit card account holders took cash advances. Still, you're likely to roll this loan into future months, too, costing yourself even more in interest payments.
How Necessary Is the Loan?
Cash advances, used sparingly and responsibly, can be an acceptable way to pay for that emergency repair or overdue bill – providing the loan isn't constantly rolled over. If the fees associated with a late payment are higher than those of the cash advance, the cash advance is probably more cost effective.
Used once or twice a year, cash advances aren't alarming. But if you find them turning into a habit, it's time for a closer look at how you're managing your money.
The Bottom Line
Cash advances are a Band-Aid solution that actually make the underlying situation worse by digging regular users deeper into debt. As CFPB Director Rich Corday explains, The stress of having to re-borrow the same dollars after already paying substantial fees is a heavy yoke that impairs a consumer's financial freedom.
Statistics show that cash advances are addictive; most people who take them don't use them just for random emergencies. If you find you regularly need a cash advance to make ends meet, drastic spending changes are in order.
Confront the problem: Ask for help from creditors, sign up for income-based payment plans where applicable and let utility companies know of your financial struggles. There's help available other than cash advances.
Once you get back on a firmer financial footing, look ahead. If you don't already have an emergency fund, find a way to start one. Check out Building An Emergency Fund and look at Investopedia's tutorial Budgeting Basics.