A couple of weeks back, Miel and I met with J, a fellow personal finance blogger who runs a very good website called Budget Are Sexy. We were having coffee and ended up getting into a debate about the relative merits of credit cards vs. payday loans. That is, in a bind which would be worse to borrow from?

We ended up wrangling about it for a good 20 minutes, and in retrospect it looks to me like the bottom line is that if you really need to borrow and can only chose between credit cards or payday loans, the credit card is a far better way to go. Why?

Payday loans are a major rip off.

What? A rip off? Yep. Payday loans can charge effective interest rates (interest & fees) that are hugely expensive. For example, in Missouri, its legally permissible to charge annual interest rates of up to 1,955%. In Montana, you can get hit with rates up to 652% and in Virgina you'll be charged an effective rate of 610%. In most other states the maximum allowed interest rate is higher than 300%. In fact, the rates are so over the top that payday lending isn't legal in some states. Congress has capped the amount of fees and interest that payday lenders can charge military personnel and consumer advocacy groups like the Consumer Federation of America hate them with a passion (1).

Credit cards aren't great, but tend to be cheaper than payday loans.

Credit Cards are obviously not an optimal way to borrow money either. Don't believe me? Congress recently had to crack down on the credit card banksters (1). Even the normally lethargic FDIC is constantly penalizing some local banks for abusive credit card lending. The tricky business practices of the credit card industry are well known by now; arbitrary rate hikes, fee harvesting, etc. etc. In addition, some people actually think widespread use of cards has a detrimental impact on public health (1).

Even though some people are credit card addicts, their effect doesn't seem as bad as payday loans. The percentage rates on credit cards are usually less than 30%. With fees the effective rates can often be higher, up to 120% if your balance is small. However, even at 120%, the cost of carrying cards is usually nowhere near the 300% you'll see with payday loans. When you think about in terms of your cost to borrow, credit cards win hands down.

Bottom line: look for alternatives to both. If you do need to borrow money, its probably best that you look for a low cost alternative. Consider a person to person loan either in an on-line outfit like Prosper.com or LendingClub.com. If that doesn't work it might be possible to borrow directly from a friend or family member. There are ways to formally do this so the relationship doesn't get akward (here).

Here are some other articles on this topic.

Payday Loans vs. Credit Cards
Credit Card Cash Advances Vs. Payday Loans
Why a Payday Loan is Better Than a Credit Card

Best,

James

P.S. In the interests of disclosure, you'll note we do have two payday links on our website. This because we DINKs gotta eat and pay the mortgage, just like the rest of you. We would of course recommend that you live frugal, save money on everday expenses, and do what you can to spot money making opportunities so that you don't end up in the bind we described above.