What Is a Payday Loan and How Does It Work?

When you’re facing an urgent financial crisis, a payday loan may feel like a gift, but it comes with very expensive strings. These loans are quick, convenient, and very easy to get; all you need is a paycheck to qualify. 

Payday lenders make it seem like you’re just getting an advance against your paycheck, but that is not true. Payday loans come with exorbitant interest rates that can make them nearly impossible to pay off, trapping borrowers in a seemingly inescapable loan cycle. If you have any other option, use it instead.

How do payday loans work?

The first time most people take out a payday loan, they think it will be the only one they ever get. They borrow a few hundred dollars fully expecting to repay it within a week or two, and then be done. 

Unfortunately, the finance charges on these loans can make it impossible to pay them back on time and in full, leading to the need for another loan to pay back the first one. Before you even consider a payday loan, understand exactly how they work and the true toll they’ll take on your financial health.

To get a payday loan, you need to show the lender a pay stub and your bank account information. Then, you tell the lender how much you want to borrow, and they put the cash in your bank account immediately. 

In exchange, you agree to pay the money plus the fee (usually called a finance charge) when you get your next paycheck. Some payday lenders require a postdated check for the total amount due; others ask you to authorize them to remove the money directly from your bank account as soon as it hits. 

If you can’t pay back the loan in full when it’s due, the payday lender will usually offer an extension or a “rollover” loan (you get a second loan from them to pay off the first loan).

How much does a payday loan cost?

Payday lenders put the loan interest in terms of a fee or finance charge, a flat dollar amount rather than a percentage. For example, the fee may be $15 (or more) for each $100 you borrow. That may not sound like much, but it works out to a pretty horrific annual interest rate. 

Charging $15 per $100 is the same as a 180 percent annual interest rate, and that’s on the low end of the payday loan finance charge scale. Even if you’re borrowing that money for just a week or two, you’re paying much more interest than you would on virtually any other kind of (non-scam) loan.

What is the maximum payday loan amount?

The amount you can borrow depends on your state’s laws and your financial situation. States that allow payday loans generally cap amounts between $300 and $1,000. Be sure to check the laws in your state.

This does not mean that you will receive the highest amount allowed by law. Your income may be taken into account by a payday lender when determining how much you can borrow. Other payday lenders, however, may not assess your ability to repay, or your other obligations, making you financially vulnerable.

How do I apply for a payday loan?

Payday loans typically require an active bank account, an ID, and proof of income, such as a pay stub. At least 18 years of age is required. Some lenders may require a Social Security number as well.

Payday loans can still be rejected, even if you have a bank account and income. Military personnel, their spouses, and their dependents may not receive loans from lenders with APRs over 36%, for example.

Does paying back payday loans build credit?

Paying off a payday loan doesn’t usually build credit. On-time payday loans aren’t reported to credit bureaus by most payday lenders, so the loan won’t improve your credit score.

Your credit may be damaged if you do not repay the loan. Credit bureaus may report a payday loan default or sell the debt to a collections agency that will do so, which will harm your credit score.

Learn more about how to build credit.

What happens if I can’t repay a payday loan?

You may be charged a late fee or a nonsufficient fund fee depending on your lender and your state. A rollover option may be available, but that usually entails a fee. Bank fees may be levied if payment isn’t acquired.

The lender can refer the loan to a collections agency if it is not able to collect the funds.

Payday Loan Traps

Because payday loans come with high-interest rates in the 150–400 percent range, they can pull you into a dangerous financial trap. 

Most borrowers are unable to repay the full amount due on their next payday, forcing them into a cycle of repeat borrowing that can last for years; there’s no limit on how many payday loans a person can get. 

Breaking this cycle can be extremely hard. The only way to get out is to stop getting payday loans. To do that, you’ll need enough money to pay off the existing payday loan in full and cover your expenses until your next paycheck comes. 

You’ll also need to go on an emergency necessities-only budget and reduce your expenses to the bone during the gap period.

Payday loan alternatives to consider

Make use of an interest-free cash advance app. With Earnin, Dave, and Brigit, you can borrow up to two days ahead of time interest-free or at a low rate on your paycheck. However, there are requirements and caps on how much you can borrow.

Credit unions and online lenders can help you get a personal loan. It’s more affordable to take out a personal loan than a payday loan, since the APR is likely to be lower. Bad-credit applicants usually get the best rates at credit unions, but you’ll need to join one. Borrowers with bad credit can also use online lenders, but interest rates may be higher.

Find out if your bank offers small-dollar loans. A growing number of banks are now offering small-dollar loans for emergency expenses. Bank of America’s Balance Assist and US Bank’s Simple Loan offer short-term funds for customers in good standing.

Borrow money from family or friends. You won’t have to go through a credit check if a loved one is willing to lend you the money. This will save you money on interest. Be sure you understand the terms of the loan, such as when it must be repaid.

Get in touch with a community organization. There are many organizations that provide free funds for essential needs. 

Another good option: Look into a payday alternative loan (PAL), available through most credit unions (if you don’t already belong to a credit union, join one ASAP). Other banks may have loans similar to PALs, just called something else. 

Unlike payday loans, PALs are set up to help you pay them off and come with high but reasonable interest rates. They also give you longer (but not much longer) than a single paycheck cycle to pay them back. 

Going with any of these options can help you break out of the vicious payday loan cycle. It’s extremely hard (and often painful) to escape, but it can be done. Once you’re free, and back to a more regular budget cycle, you can start taking steps (like building an emergency fund) to make sure you’re never again in a position where a payday loan is your best or only option.

Payday loan alternatives to avoid

Long-term, high-interest installment loans: As long as five years are allowed for repayment on these loans. Payday loans do not require good credit – some may advertise themselves as no-credit-check installment loans – but you must typically meet the requirements. In two years, a $3,200, 87% APR loan will cost $6,844 in interest payments.

Auto title loans: You have to put up your car title as collateral for these short-term loans, where they’re legal. If you don’t repay, the lender can seize your car. They’re often compared to payday loans, but they’re even worse.

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