What is a Payday Loan? Benefits & Risks of High-Interest Loans

A payday loan is a small amount of money that consumers can borrow and then pay back when they receive their next paycheck. This type of loan is helpful if you need cash quickly, perhaps because you have an unexpected expense between paychecks. You typically must repay these loans within one to four weeks.

Payday loans have very high interest rates, which means you will pay back a lot more money than you borrowed. In this guide, I’ll cover everything you need to know about payday loans and why you should only use them in an urgent situation when you have no other options to get money.

Payday loans can be extremely helpful or terribly dangerous. Before you consider getting one, it pays to have a thorough understanding of how they operate and how much they cost.

High-Interest Loans With Quick Repayment Terms

When you take a high-interest payday loan, you agree to pay it back as soon as you receive your next paycheck. This type of loan can help you in emergencies when you urgently need cash.

Here are some important elements of a payday loan:

• Application Process: The steps to apply for a payday loan are usually quick and require minimal documentation, such as proof of income and identification
• APR (Annual Percentage Rate): The yearly interest rate of the loan, including fees and other costs, is very high for payday loans — typically 300% to 700% or more
• Automatic Debit: A repayment method that allows the lender to automatically draw the loan repayment from your bank account on the due date
• Capitalization: When you roll over a payday loan, unpaid interest and fees are added to the principal of a new loan, increasing the total debt
• Financing Charge: The loan’s interest as a flat fee
• Loan Amount: A payday loan typically allows you to borrow between $50 and $500
• Post-Dated Check: A check written with a future date for repayment, which the lender cashes on that date to obtain the loan repayment
• Purpose: The reason for taking out a payday loan is typically to cover urgent cash needs until your next paycheck arrives
• Repayment Terms: The period you have to pay back the payday loan is usually from one to four weeks, ending on your next payday
• Rollover: If you cannot pay on time, the loan’s due date will be extended, usually with additional fees and increased interest

A payday loan usually allows you to borrow a small amount of money, and the time you have to pay back the loan is short, typically just until your next payday. 

Because you need to pay back the money quickly and the loan has a high interest rate, it is important to be sure you can return the money on time to avoid extra fees.

The Typical Payday Loan Borrower

Most payday loan borrowers are adults who need quick money to cover expenses before their next paycheck. These borrowers may have low-paying jobs and don’t have enough savings to handle unexpected costs. They come from various backgrounds, but many have limited or no access to other types of credit, such as bank loans or credit cards.

People choose payday loans because they are fast and usually easy to get. You don’t need good credit to apply, which makes them a popular choice for those who have trouble getting approved for other financial products.

Also, the process is quick — you can obtain money the same day or the next day, depending on how you apply. This is very helpful for urgent expenses such as fixing a car or paying a medical bill.

Payday borrowers often need to take out repeated loans to cover the high fees and interest of the initial loan. Some borrowers fall into a debt spiral because they can never catch up on their loans. This can result in a dire financial situation.

Statistics show that millions of people use payday loans each year. For example, it’s common for about 10% of adults in some areas to use a payday loan in a given year. Some reports suggest that over 80% of payday borrowers either roll over their loans or take another loan within 14 days.

Consumers who roll over their payday loans often do so several times. On average, borrowers who fall into a cycle of payday borrowing roll over their loans four or more times.

The Consumer Financial Protection Bureau (CFPB) notes that a large percentage (about 45%) of single-payment payday loan customers reborrow on the same day or shortly after they pay off a previous payday loan.

In fact, borrowers renew one in seven payday loans more than 10 times. For this reason, some states have modified payday lender practices or have banned these loans outright.

Where to Find a Payday Loan

The two common sources of payday loans are storefronts and online platforms.

A payday storefront is a brick-and-mortar location where you can go to apply for payday loans. You speak directly with the lender, fill out the application, and receive cash or a check if you get loan approval. The entire transaction may take only minutes.

An online payday loan lets you apply over the internet. You can use a network website that connects you to one or more direct lenders. You complete the application process on a lender’s website and receive a quick decision.

If approved, the lender deposits the money directly into your bank account, often on the next business day. Online payday loans are convenient, private, and available 24/7.

It would be best if you chose a safe and trustworthy payday lender. Here are some tips to help you find one:

• Check for Licensing: The payday lender must have a license to operate in your state. You can check this information on your state’s financial regulator’s website or the attorney general’s office.
• Read Reviews: See online what customers say about their dealings with the lender. Pay close attention to comments about the lender’s customer service.
• Understand the Fees and Terms: Make sure you fully understand fees, the interest rate, and the terms of repayment. A reputable lender will clearly explain these details without hiding any extra costs.
• Avoid Lenders with Multiple Rollovers: Some lenders may encourage you to roll over your loan multiple times, which leads to more debt. Reputable lenders will not push you into a cycle of debt.
• Look for Transparency: A trustworthy lender will be very clear about all loan terms and costs on their website and in any communications. They should provide easy access to their contact information and customer service.
• Avoid Promises That Sound Too Good to Be True: Be cautious if a lender guarantees approval. Reputable lenders will perform some identity checks and employment verification.
• Check with the Better Business Bureau (BBB): See if the BBB accredits the lender and check their rating. Also, look at any complaints and their resolutions.

By following these tips, you can be more confident you are dealing with a reputable payday lender who will treat you fairly.

Legal and Regulatory Compliance

Both state and federal laws regulate payday loans. These laws decide how much you can borrow, the fees lenders can charge, and the repayment terms. Each state has its own rules, and some 18 states do not allow payday loans at all.

Federal laws, including the Truth in Lending Act, require lenders to show you the cost of the loan in terms of the annual percentage rate (APR) and other specifics before you agree to the loan.

Payday lenders can face serious penalties if they do not follow these laws. These penalties can include fines, the loss of their operating license, or even legal action against them.

For example, suppose a lender charges more than the law allows. In that case, they may have to pay back the extra charges (and perhaps penalties for damages) to borrowers.

Laws and regulations regarding payday loans can change frequently. Recently, some states have tightened rules to protect consumers. These changes may include lowering the maximum interest rates lenders can charge or limiting how often you can take out payday loans (to deter rollovers and debt cycles).

If you’re considering a payday loan, check the most current laws in your state to understand how they affect the industry.

Payday loans are controversial due to their high costs. However, millions of people use them each year because they can’t borrow elsewhere. Here is a rundown of some payday loan benefits and drawbacks.

Benefits

Payday loans have a few benefits for borrowers who have limited access to loans. They are fairly easy to get and provide some repayment flexibility (albeit at a high cost).

• Quick Access to Funds: Payday loans can be a helpful option when you need money quickly. After the lender approves your application, you can often receive the money within a day or even in just a few minutes.This quick access is especially useful for emergency expenses, such as when you need to pay for repairs or unexpected bills right away.

• Easy Application Process: Applying for a payday loan is usually very easy. You need to provide only a few pieces of information, such as your identification, proof of income, and bank account details. You do not have to submit to a credit check, nor do you need any credit history. Many lenders also allow you to apply online, which means you can do it from home without having to visit a store. Online finder servicers can send your application to multiple lenders at the same time, ensuring your request gets wide distribution. This encourages competition and increases your odds of finding a suitable payday loan.

• Borrowing Flexibility: Payday loans offer flexibility because you can use the money for almost any purpose. Whether you need to cover an unexpected expense, pay a bill before your next paycheck, or handle an emergency, a payday loan can provide the funds you need. Also, the amount you borrow can vary, giving you the option to choose how much you need based on your immediate financial requirements. Rollovers add repayment flexibility, although they make expensive loans even more costly.

Drawbacks

Most drawbacks of payday loans stem from their astronomical costs. Rollovers make them even more expensive, and failure to repay can lead to credit-damaging collections.

• High-Interest Rates: The APR on payday loans is usually very high, ranging from 300% to 700% or more. This rate includes the interest and any fees the lender may charge on the loan. The APR shows the cost of the loan over a year, which makes it a good way to compare with other credit products.
• Fees That Lenders May Charge: In addition to high interest rates, payday loans may include additional costs, such as late fees, which lenders may charge for rolling over the loan. These fees increase the total cost of borrowing.
• Comparisons to Other Credit Products: Compared to other credit options, such as credit cards or personal loans, payday loans are much more expensive. For example, a typical credit card or personal loan APR may range from 10% to 36%, significantly lower than the APRs for payday loans.

Debt Cycle Considerations

Falling into a debt cycle can seem like a slow financial death. It can ruin your entire lifestyle or worse, so keep these considerations in mind:

• Recurring Debt: High costs and short loan deadlines make it difficult to repay on time. This often leads to costly rollovers.
• Real-Life Examples and Borrower Testimonials: Some borrowers state that they wanted to use a payday loan for an emergency but took out additional loans to cover the earlier one.
• Other Ways to Avoid the Cycle of Debt: Try borrowing from friends or family, getting an advance from your employer, or applying for small personal loans from banks or credit unions.

Possible Impact on Your Credit Score

Payday loans can only hurt your credit score. Look elsewhere for loans that help you build or rebuild credit. The following points are important to remember:

• Payday Lenders and Credit Reporting: Generally, payday lenders do not report your loan payments to the credit bureaus. However, lenders may report missed payments, which can hurt your credit score.
• Impact of Non-Payment: A collection agency may notify the credit bureaus If you don’t repay your loan. A collection account remains on your credit report for seven years.

These drawbacks are considerable and demonstrate why you should apply for payday loans only as a last resort.

In this example, Susan takes a $100 payday loan with a $15 finance charge. Repayment is due in two weeks. Susan rolls over the loan on the due date, and the lender tacks on a $10 late fee (which is legal in Susan’s state). It capitalizes the original $15 finance charge and imposes a new $15 finance charge with the $10 late fee.

Initial Loan Details

Susan accepts the following terms:

• Principal: $100
• Finance Charge: $15
• Loan Term: Two weeks

Calculate the APR by dividing the finance charge by the principal and then converting that to an annual rate:

Finance charge = $15 per period / $100 = 0.15 = 15% per period

Multiply the periodic interest rate by the number of two-week periods in a year:

APR for first period = 15% per period × 26 periods = 390%

Scenario After Rollover

When calculating the APR after a rollover with a late fee, the principal is the total amount due after all additions — $140. Of the $40 charge, $15 represents the original finance charge, $15 is the new finance charge, and $10 is the late fee.

• Total Finance Charge for the New Period: $25 (new finance charge + late fee)
• New Total Due: $140 (previous due of $115 + new finance charge of $15 + late fee of $10)

Finance charge as a percentage of principal = $25 / $140 = 0.1786 = 17.86%

APR for second period = 17.86% × 26 = 464.36%

Final Summary

Susan pays the lender $140 four weeks after taking the initial $100 payday loan. This $40 cost consists of $30 in finance charges and a late fee of $10.

To calculate the overall APR of the loan:

Charges as a percentage of the principal = $40 / $100 = 0.40 = 40%

The number of four-week periods in a year is 52 weeks / 4 weeks = 13 periods.

APR = 40% per period × 13 periods = 520%

This example illustrates how rolling over a payday loan can lead to snowballing costs. Left unpaid, the debt can grow so large that the borrower begins to miss payments on payday loans and other obligations.

You must satisfy specific requirements to get a payday loan. These vary by lender and state, but usually include:

• Age: You must be 18 or older.
• Income: Prove your steady income with recent pay stubs or bank statements.
• Bank Account: You usually need an active checking account.
• Valid Identification: Lenders want a valid government-issued ID to confirm your identity and age.
• Contact Information: Your phone number and email address enable the lender to communicate with you.
• Residency: You must prove you live in the state where you are applying. You can use a utility bill, mortgage statement, or lease agreement.
• Social Security Number (SSN): Your SSN helps the lender verify your identity.
• Credit Check: Some payday lenders do a soft pull to confirm your financial history.
• Not Currently Bankrupt: You cannot currently be in bankruptcy proceedings or planning to file.

These requirements allow lenders to breathe easier. They want to minimize the odds that you’ll default on the loan.

When you need money quickly, consider different options, such as personal loans, credit cards, or payday alternative loans. Understanding your options can allow you to make the best choice.

Credit Cards

Credit cards have lower interest rates than payday loans. While payday loan APRs can go as high as 700%, credit card interest rates typically range from about 15% to 36%.

You usually need a fair to good credit score to get a decent credit card. Still, some issuers offer products to consumers with bad or limited credit. Payday loans are much easier to access, especially if you have poor or no credit.

Credit cards allow you to borrow money up to your credit limit. You can use the funds for purchases, bill payments, and cash advances. You won’t incur any interest If you pay the entire monthly balance by the due date.

This makes credit cards a more flexible and less expensive option than payday loans. If you use them responsibly and make payments on time, credit cards can also help you build your credit score.

The risks of payday loans include very high interest rates and the potential to enter a debt cycle due to frequent rollovers. If you don’t pay back a payday loan on time, you could face hefty fees and damage to your financial health. 

For credit cards, the risks include the possibility of falling into debt if you consistently spend more than you can afford and only make minimum payments. This can also lead to higher interest charges over time and could harm your credit score.

Installment Loans

Installment loans allow you to borrow a specific amount of money all at once and pay it back in fixed payments, or installments, over a period of time. These payments usually include both the principal and interest.

The pros of choosing installment loans include:

• More Manageable Payments: Because you repay an installment loan over a longer period, the individual monthly payments can be smaller and more manageable compared to the full amount due at once with a payday loan.
• Lower Interest Rates: Installment loans have lower interest rates than payday loans, which can save you a bundle.
• Credit Score Improvement: Regular, on-time payments can help build your credit score. Payday loans can’t do that.

The drawbacks of installment loans include:

• Longer Debt Commitment: You will be in debt for a longer time than you would for a payday loan.
• Potential for Higher Overall Cost: Large, long-term installment loans may have a higher overall cost than a small, short-term payday loan.

To qualify for an installment loan, you typically need to meet more stringent credit requirements than for payday loans. Lenders will look at your credit score, credit history, current income, and sometimes debt-to-income ratio to determine your ability to repay the loan.

Installment loans are widely available from banks, credit unions, and online lenders. They are most accessible to those with fair to good credit profiles. However, some lenders offer installment loans that cater to consumers with poor or no credit. Expect interest rates to vary directly with credit scores.

Choosing between a payday loan and an installment loan may depend on your financial requirements, credit profile, ability to repay the loan, and need for funds. You’ll save money if you qualify for an installment loan instead of taking a high-cost payday loan.

Payday Alternative Loans (PALs)

Payday Alternative Loans (PALs) are available through participating federal credit unions. They are a low-cost loan option for credit union members.

Most credit unions require a minimum deposit of $5 to open an account. Many also have acceptance criteria related to where you work, live, or worship.

PAL I

After joining a credit union, you must wait 30 days before you can apply for a PAL I. This loan offers amounts ranging from $200 to $1,000, with repayment terms between one to six months. The application fee is, at most, $20.

PAL II

You can apply for a PAL II immediately upon becoming a credit union member. This loan allows you to borrow up to $2,000, with an application fee between $40 to $50, and you can take up to a year to repay.

Both types of PALs are for credit union members with subprime credit and feature interest rates that do not exceed 28%, making them a cost-effective lending option.

Payday loans can seem like a quick solution when you need cash fast, but they come with high risks. Understanding these risks can help you avoid financial disaster.

Don’t Borrow More Than You Need

Borrowing more money than you actually need can saddle you with unnecessary debt and make it really hard to repay a loan. You end up paying much more in interest and fees, which can send you spiraling into a financial nightmare.

Be honest with yourself before you borrow money. Carefully consider why you need a loan. Calculate the exact amount necessary to pay for your immediate need. This helps prevent overextending yourself.

Overborrowing can strain your pocketbook for months or even years. It can impact your ability to save or achieve future financial goals. Always consider the long-term consequences of any debt you take on.

Research Better Alternatives

Think about better choices before you decide on a payday loan. For example, try a credit counseling program that can help set up a budget and possibly consolidate your debt. Also, consider small personal loans or PAL from banks or credit unions because they can save you money and have more flexible repayment terms.

Choosing something other than a payday loan can save you money because you’ll pay less in interest and fees. Alternative loans may also help you handle your money better, which could make it easier and cheaper for you to borrow in the future.

Have a Plan for Repayment

Know exactly how you will repay a loan before you take it. This helps you prevent missed payments and additional fees.

Use budgeting tools or financial apps to track your expenses and income. Create a budget that includes your loan payments. Doing so ensures your loan fits within your monthly financial plan.

Look online for examples of individuals who successfully repaid their loans. Many use strict budgeting, timely payments, and even extra payments to reduce their debt quickly. Employ these strategies to manage your own debt better. 

If you are considering a payday loan, understand exactly how much money you need and only borrow that amount. You usually have better options, so also be sure to explore those and always ensure you have a plan for how you’ll pay back the money.

Think carefully and pick the best option for you. It will likely be the one that won’t make things difficult in your daily life.