Refund-anticipation loans

There are a lot of recipes for financial disaster, but here's one that's simple, straightforward and common:

Start by making an interest-free loan to a friend, so that your money is tied up, and you earn nothing on it.

Next, decide that you can't wait a few weeks for repayment, so that you go out and borrow an amount equal to your original loan. Along the way, pay big fees and interest charges — because you're the only one fool enough to make an interest-free loan — so that you wind up with maybe 80 cents of your dollar back.

There's a name for the financial mess you're cooking here: It's called a "refund anticipation loan," and it's a Stupid Investment of the Week.

Stupid Investment of the Week highlights the problems that make an investment less than ideal for average consumers, and is written in the hope that pointing out trouble in one situation makes it easier for readers to uncover elsewhere on their own.

Typically, loans aren't investments, but they qualify for this column because it's a commitment of money, over time, to get an expected "return," namely the use of the proceeds. With refund-anticipation loans, the best news for anyone suckered into one is that the whole experience will be over as soon as the Internal Revenue Service ponies up your cash.

Refund-anticipation loans go by a lot of names, but no matter what you call them, they are flawed from the standpoint of sound financial management.

First off, there's the simple idea that to get a tax refund, you're overpaying taxes — diminishing current cash flow in the process — and effectively giving Uncle Sam an interest-free loan.

Many consumers consider their refund a form of "forced savings," but that's probably not the case for someone so desperate to get cash now that they'll take out a loan to get it. (The IRS now allows refunds to be directed to different accounts; forced savings might involve splitting the payback between an emergency account, an individual retirement account and college savings, but no one needs to get their cash a few weeks early to make those investments.)

Quick-refund loans, effectively, are like a payday-advance loan, except they attach to the tax refund rather than a paycheck.

While many consumers find the payday-advance loan business sleazy and creepy — because it operates out of everything from spam e-mails to dive storefronts to loud Web sites — the refund-loan business emanates from someone they trust, their tax preparer.

In most cases, the tax preparer — or tax-preparation Web site — offers advances as an "additional service," offering to pay out the anticipated refund amount, minus tax-preparation fees and additional loan costs.

"You go to get your taxes done, and they show you how much you'll get back, get you excited about it and then hit you with a pitch to get it back sooner," says Linda Sherry of Consumer Action, an advocacy and educational organization. "The marketing tactics are inappropriate, and the consumer doesn't realize the conflicts of interest involved in preparing the return, and then selling a loan based on the refund."

Fees vary widely, and while they are disclosed before the paperwork is signed, they're just about the last thing a consumer finds out about in making one of these deals. The Consumer Federation of America and the National Consumer Law Center recently issued their annual study on refund-anticipation loans, and noted that the average loan of just over $2,000 (after filing fees have been paid) will cost about $100.

That's 5 percent of the loan amount.

It sounds cheap, until you consider the time frame, namely days or weeks. The effective annualized rate of interest is frightening. Simply put: An annualized rate of about 40 percent for these loans would be a bargain.

The less you borrow, the worse the situation. The Consumer Federation study concluded that the effective rate on a loan for the average refund is 178 percent, but that it's over 700 percent on a 10-day loan of just $200. (This is one reason that the IRS and the Free File Alliance — a coalition of tax-preparation software makers — recently agreed to drop loan solicitations from the program, which makes filing software available free for low-income taxpayers, the kind who get smaller refunds.)

And, yes, all this hubbub is for a loan that may last as little as a week to 10 days. At H&R Block, for example, the company Web site informs consumers that their refund options include mailing in a return — so that the refund won't arrive for five to eight weeks — or filing electronically, which makes a refund available in eight to 15 days, or up to three weeks if you ask the agency to mail you a check rather than depositing the cash into your accounts.

Refund-anticipation loans can range from "instant" — where the credit checks are higher — to waiting periods of up to 48 hours, which is a long time when you're only beating the regular refund by two weeks.

"These loans take the maxim 'Time is money' to the extreme," says Greg McBride, senior editor at Bankrate.com. "Relatively speaking, you're paying a lot of money to save very little time."

Even if you do save some time, there is always the chance that it costs you even more in the end. If Uncle Sam throws a wrench in your refund plans and pays you less than anticipated, you'll be left owning money to the lender at those high rates. That's not what you bargained for; instead of delivering some financial relief, you wind up with a high-rate bill to pay.

Says Sherry: "If you're living paycheck to paycheck, you're still better off waiting and getting all of their money back, and then adjusting their withholdings so that your regular paycheck is bigger next year. This is your money; paying fees and interest to get it back a few weeks early — and running the risk that you may still owe more — is just not worth it."

Chuck Jaffe is senior columnist for MarketWatch. He does not own or hold short positions in any securities covered by Stupid Investment of the Week. If you have a suggestion for Chuck Jaffe's Stupid Investment of the Week or a comment about this week's column, you can reach him at jaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.