Wednesday, July 25, 2012

Payday Loan or Tax Refund Loan: What's the Difference?

Taxes have a way of befuddling even the most financially savvy of individuals. When faced with a seemingly endless pile of W2s, I9s, and other tax forms, it is easy to lose track of how much of a refund one is really entitled to. Often times, people unwittingly cut their refund short while figuring out their taxes, while others overestimate the amount of the return. This can be potentially dangerous for individuals who anticipate a large return only to be faced with a portion of what they expected. This is particularly true for individuals who borrowed a tax refund loan only to find out that the refund isn't as much as they had hoped.

With any unexpected shift for the worst in finances, the risk of loan dependency increases. When faced with such circumstances, an individual may seek out a payday loan to cover unanticipated costs. However, using a payday advance to cover the costs of a tax refund loan is in essence compiling debt upon debt. This raises they questions: Should tax refund loans be avoided? Is a payday loan a better bet to begin with? In order to distinguish between these two types of loans and to determine when and if either should be used, it is important to define how each functions.

What is a tax refund loan?

A tax refund loan allows an individual to borrow against their anticipated tax return. While this seems like a relatively safe endeavor, it is actually more dangerous than it appears because individuals are offered a loan on their refund prior to IRS approval. Often, an individual will submit tax paperwork confident that his/her calculations are correct only to have the IRS discover a flaw in his/her math and/or a missed credit. While this can work in the favor of the person filing his/her taxes if the IRS discovers that the individual shorted him/herself, it can also have a negative outcome if the IRS finds that the individual owes more than he/she anticipated. Because a tax refund loan is based on a projected, but not absolute, refund amount, the borrower may end up owing more on the loan than the tax return can cover.

Because the loan amount is based on a projection, the lender can manipulate the tax forms to make it seem like an individual is getting a larger refund than they are actually entitled to. They do this in order to increase the loan amount and earn more interest. Yet, this shady practice can leave a borrower with a refund that simply isn't enough to cover the loan amount. As such, the borrower is left with debt.

In contrast, payday loans are granted based on a percentage of one's income. Because income is often more stable from week to week than yearly tax returns, payday loans can provide a more secure means to acquire quick cash. Payday loans lenders keep the loan amounts small, unlike tax refund loan lenders, so that the person can repay the loan on time and in full. However, these loans can be borrowed repeatedly, week after week, and can thereby turn into a large debt due to interest rates.

Thus, while payday loans are a better option that tax refund loans, they come with their own set of risks and should only be used when necessary and as intended. If treated responsibly and paid back quickly, they can be useful in sticky financial situations.

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