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What Is A Payday Loan, And How Does It Work?

5-minute read

Payday loans can be tempting: They promise fast cash with no credit checks. That can be appealing if you’re facing a financial emergency.

But be careful: Payday loans can provide you with a chunk of cash, but that cash comes at a high price. And that price will become even steeper if you fail to pay back your payday loan on time.

What Is A Payday Loan?

There is no one definition of what a payday loan is. But the Consumer Financial Protection Bureau says that these loans are for small amounts of cash – $500 or less, usually – and due in a short time, usually on the date of your next payday.

You can find these loans from private lenders, many of which state that they specialize in payday loans. Qualifying for these loans isn’t a challenge: As the Consumer Financial Protection Bureau says, payday lenders often promise that they’ll approve borrowers for these loans without first checking their credit or their ability repay.

People often turn to payday loans – also known as payday advance, cash advance, deferred deposit and check advance loans – when they need a small amount of cash in a hurry. Maybe someone needs money to pay the electric bill. Some borrowers might need fast cash to pay for repairs on a car.

The problem is that borrowing money in this way can get very expensive. The fees that payday lenders charge can be high. It’s why agencies such as the Consumer Financial Protection Bureau and the Federal Trade Commission recommend that borrowers search for alternatives to payday loans.

How Do Payday Loans Work?

Getting a payday loan is relatively simple:

  • According to the Federal Trade Commission, borrowers write a personal check payable to the payday lender for the amount they want to borrow plus any fees.
  • Lenders then give the borrowers the amount of the check less the fee. They hold onto this check until borrowers repay the loan. This repayment date is usually the same as the next payday for the borrowers. Other borrowers must give payday lenders authorization to electronically withdraw the funds from their bank, credit union or prepaid card account, according to the Consumer Financial Protection Bureau.
  • If borrowers don't repay their loans on or before their due date, lenders can cash their check or electronically withdraw the money from their accounts.
  • These loans are not cheap. The Consumer Financial Protection Bureau says that many states set a maximum amount for payday loan fees that ranges from $10 – $30 for every $100 borrowers take out. According to the bureau, a 2-week payday loan with a fee of $15 for every $100 paid out comes out to an annual percentage rate, or APR, of nearly 400%.

APR is a measure of how much it costs to borrow money. As a comparison, the Consumer Financial Protection Bureau says that APRs on credit cards typically range from 12% – 30%.

The Dangers Of Payday Loans

While payday loans might seem convenient, they come with many potential dangers.

They cost too much: The fees that come with payday loans are high. The Federal Trade Commission said that it’s not unusual for lenders to charge $15 or more for every $100 you borrow. If you borrow $500, you’d pay $75.

Rollover fees: When your due date arrives, your lender might offer you the chance to rollover your loan until your next payday. This means you wouldn’t have to repay your loan for, perhaps, another 14 days. This service isn’t free, though. Lenders will charge you another fee for this rollover. As an example, maybe you borrowed $100 for a fee of $15. When your due date arrives, you decide to rollover your loan for another 2 weeks. Your lender charges you another $15 for this. This means that your fees have now increased to $30. It’s easy to rack up hefty charges this way.

You might not be able to get one: Depending on where you live, you might not be able to take out a payday loan. According to the National Council of State Legislatures, 37 states have specific statutes that allow for payday lending. Arizona, Arkansas, the District of Columbia, Georgia, New Mexico and North Carolina prohibit payday loans.

They won’t help your credit: Making regular, on-time payments on your mortgage, auto, student or personal loans will boost your three-digit FICO® credit score. That’s because lenders report these payments to the three national credit bureaus of Experian, Equifax® and TransUnion®. The same doesn’t hold true for payday loans. Payday lenders don’t report your payments to the bureaus. Because of this, your on-time payments won’t help your score.

There are limits to how much you can borrow: Depending on your financial emergency, a payday loan might not provide much help. That’s because many states limit how much people can borrow from payday lenders. For instance, in New Hampshire, you can’t borrow more than $500; in California, you can’t take out a payday loan for more than $300.

Payday Loan Alternatives

You don’t have to rely on payday loans. There are alternatives if you need money, even if you need it quickly.

Personal loans: You can seek out a personal loan with a private lender if you need funds. With a personal loan, a lender gives you a lump sum of cash. You then pay it back each month, with interest. The benefit here is that you can borrow a larger amount of money at a time. For example, you can take out a $10,000 loan from Rocket Loans® at an interest rate of 11%. If you take out this loan for 5 years, you'd pay $217.42 each month until the loan is paid back. The APR with this loan – 13.26% – is much lower than you'd get with a payday loan.

The challenge is that lenders will check your credit before approving you for a personal loan. If your credit score is too low, you might not qualify.

Asking for help from friends and family members: If you are facing a financial emergency, family members or friends might be willing to loan you money. Usually, they’ll loan you money with no or low interest. The possible downfall? You could damage these relationships if you don’t pay back your loan on time.

Peer-to-peer lending: In peer-to-peer lending, several different investors pool their funds together, in small increments, to provide a loan to borrowers. These investors earn a profit when the borrower repays the loan, with interest.

Peer-to-peer lending usually takes place online, with borrowers applying for loans through online marketplaces.

Again, borrowers will need a high enough credit score to qualify for peer-to-peer loans.

Paycheck advance: If you’re facing a financial emergency, you can ask your employer for an advance on your paycheck. Your employer might agree to give you, say, $1,000 today even though you aren’t scheduled to receive your paycheck of $4,000 until next week.

The downside here? Your employer might not agree to front you the money you need. Many employers have policies prohibiting such advances. It can also be embarrassing to ask employers for advances.

Summary: Should You Get A Payday Loan?

You should always search for alternatives to payday loans. These loans are simply too expensive. If you find yourself facing a financial emergency, search for alternatives. Don’t let your need for quick cash lead you to a short-term loan that comes with such heavy fees.

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