What is a Payday Loan and How Do They Work?

A payday loan is a type of short-term, high-interest personal loan that becomes due when you get your next paycheck. Payday loans may look appealing in a cash crunch, particularly for people with low credit scores. But the fees and interest are exorbitant, leading many borrowers to become trapped in a debt cycle where they take out loan after loan.

In this article, we’ll explain how payday loans work and why they’re so much riskier than other forms of consumer loans. We’ll cover the true cost of payday loans in terms of interest rates and finance charges, as well as what happens when you can’t repay the loan. Finally, we’ll explore some alternatives if you need to borrow money before your next payday.

What Is a Payday Loan?

A payday loan is a small-dollar loan, often for $500 or less, that typically becomes due in two to four weeks. The due date often corresponds with the borrower’s next payday or when they receive another source of income, like a Social Security, disability or pension check. Payday loans are sometimes referred to as cash advance loans or check advance loans. Because they don’t require collateral, payday loans are a type of unsecured loan.

Though payday loans are frequently advertised as a resource for borrowers facing an emergency or a one-time unexpected expense, that’s not how most borrowers use these high-cost loans. A study by The Pew Charitable Trusts found that 69% of borrowers used payday loans for regular bills and recurring expenses.

Payday loan services are available both online and through storefront payday lenders. The rules for payday loans depend on your state laws. Many states limit the interest rates or the maximum loan amount or the loan term. A handful of states ban payday loans altogether.

In recent years, though, many states have cracked down on high-interest payday loans. Not surprisingly, payday lenders have fled states that have imposed interest caps. The Pew Charitable Trusts reports that payday lenders operated in 44 states as of 2004; by 2022, that number had dropped to 32 states.

How Does a Payday Loan Work?

Most payday lenders don’t require a credit check to borrow money. Nor do they consider your expenses, debt or ability to repay the loan. Payday lenders also won’t report payments to the credit bureaus, so the loan won’t appear on your credit report.

Payday loan borrowers typically need to provide identification, proof of income and bank account information. The payday lender will also require the borrower to do one of the following:

• Provide a post-dated personal check coinciding with the date of their next paycheck.
• Authorize an ACH (automated clearing house) transfer that allows the lender to electronically withdraw money from your bank or credit union account.

Once the loan is approved, you may receive the money in the form of cash, a check, a prepaid debit card or an electronic deposit.

The due date and repayment terms for the loan will be included in the loan agreement. Many payday loans are due in one lump sum payment.

However, some payday loan lenders also allow the money borrowed to be repaid in installments. Depending on state laws, the borrower may be able to roll over or renew the loan. The latter option is especially dangerous for borrowers because they risk becoming trapped in a debt cycle, which we’ll explain shortly.

Payday Loan Costs

Payday loan costs range from $10 to $30 per $100 borrowed in states that don’t impose interest rate caps, according to the Consumer Financial Protection Bureau. A $15 fee per $100 borrowed is fairly typical.

A $15 charge on a $100 loan may not sound like much. But on a two-week loan, that works out to an annual percentage rate (APR) of nearly 400%.

Payday loans are one of the most expensive sources of consumer credit. By comparison, the average credit card APR was 16.17% as of February 2022. For a 24-month personal loan, the average APR was 9.41%, according to the Federal Reserve.

Payday Loan Dangers

The real danger occurs when you don’t have money to pay back the loan. Remember: The lender has access to the borrower’s bank account or a pre-dated check.

When you don’t have the funds to cover repayment, you could incur hefty overdraft fees from your bank. If the loan causes other transactions to bounce, the loan could result in multiple fines.

Payday Loan Example

Amy can afford to pay her monthly expenses, but she pretty much lives paycheck to paycheck. Then, her rent increases by $150 the same month her child’s daycare bill goes up by $150. That means Amy needs to come up with $300 fast. So she goes to a storefront payday lender and applies for a $300 loan this month while she figures out how to address her monthly shortfall.

To borrow $300, Amy has to pay a $45 finance charge. That doesn’t sound like a lot. But the loan is due in 14 days, on Amy’s next payday. That means Amy is paying an APR of nearly 400%.

But when the loan comes due, Amy doesn’t have $345. The money she borrowed went toward her higher rent and daycare expenses. So she pays a $45 fee to roll over the loan. She now has spent $390 on her $300 loan.

If Amy is an average payday loan borrower, she’ll continue this cycle for five months before paying off the loan. Assuming she rolls over the loan every other week until 22 weeks (roughly five months) after she took out the initial loan, she’d pay $495 in fees. That’s $795 total to pay off a $300 loan.

Unfortunately, chances are high that Amy will take out more payday loans. According to the Consumer Financial Protection Bureau, nearly 70% of payday loan borrowers take out a second payday loan within a month. Roughly 1 in 5 borrowers will take out 10 or more payday loans.

What if You Can’t Afford to Repay a Payday Loan?

If you can’t repay a payday loan, you can expect debt collectors to start hounding you. While a collection agency can sue you and possibly win a judgment to garnish your wages, you won’t be jailed over this debt, no matter what any collector tells you. (In fact, it’s illegal for debt collectors to falsely tell you you’ll be arrested over debt.)

While defaulting on a payday loan can have serious consequences, you still want to prioritize your basic needs over your debt. Prioritize rent, food, medications and vehicle payments if you need your car for work. Consider these options for payday loan relief.

Revoke ACH Authorization

If you gave the payday lender authorization to electronically withdraw money from your account, you can contact your bank or credit union and tell them the lender no longer has permission to debit your account. That doesn’t change the amount you owe, of course. You can expect the payday lender to continue its collection efforts. Many financial institutions will also charge you a fee. But at the very least, you can stop the lender from taking money you need for essentials, like rent or food.

Note that when you apply for online payday loans, it’s often difficult to tell if you’re applying with an actual lender or a lead generator that sends your information to lenders. As a result, many payday borrowers don’t know whom they actually owe.

Ask for a Payment Plan

Some states require lenders to offer borrowers a payment plan without charging extra fees. In other states, lenders must allow struggling borrowers to enter a payment plan, but they’re allowed to tack on additional fees.

Regardless of your state’s law, it’s often in a lender’s interest to work with you. If you can afford to pay a lump sum that’s less than the balance, offer it up. Another option is to tell the lender you’re so overwhelmed by bills that you’re considering bankruptcy. Many lenders are willing to compromise in this situation because they know it’s likely they wouldn’t get anything in bankruptcy court.

Get Credit Counseling

If you’re overwhelmed by payday loans or any other kind of debt, credit counseling is a good option. Look for a nonprofit agency through the Financial Counseling Organization of America or the National Foundation for Credit Counseling (NFCC). A credit counselor can help you determine whether a debt consolidation loan or debt management plan is possible. They can also discuss whether you need to consider bankruptcy.

Ask Friends or Family

If you’re in a bind, consider asking a friend or family member if they could help out, either by lending you money or giving you cash outright. Just make sure you’re being honest about your ability to pay them back.

Take on Extra Work

If you can’t afford your payday loan or payday loans are your only option for paying your regular bills, making more money may be the only fix. Consider taking on a side gig or finding other options for making money fast.

Payday Loan Alternatives

If you haven’t taken out a payday loan yet, you have other options. Here are some payday loan alternatives to consider first:

• Payday alternative loan (PAL): Some low-income credit unions offer small loans called payday alternative loans that typically range from $200 to $2,000. Interest rates are capped at 28% with no rollovers allowed. You’ll need to be a member of the credit union to qualify.

• Credit card or cash advance: Many people turn to payday loans because they don’t have access to traditional credit. However, if you do have a credit card, charging expenses to your card or getting a cash advance will almost certainly be cheaper than a payday loan if you live in a state with no interest rate caps.
• Bad credit personal loans: Even if you have a low credit score, you may qualify for a  bad credit personal loan with a lower interest rate than a payday loan.

Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected].

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