What is a Payday Loan?

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Definition:

A payday loan is an expensive, short-term loan aimed at people who need a small amount of cash to make it to their next payday.

🤔 Understanding payday loans

Most people get their paychecks on a regular schedule, often every other week. Those who don’t make much often can’t build a savings account. When emergencies arise between paydays, or when there’s no money left for essential purchases, they need quick cash to get by. Often, payday lenders target people who already have credit card debt and who can’t go to friends or family for financial help. These short-term loans are designed to help people bridge the gap until their next payday. They usually come with high interest rates and fees that can put borrowers at risk of entering a vicious cycle of debt.

Example

Imagine you run out of money a week before your next paycheck will arrive. You need to cover some expenses, so you apply for a $300 payday loan. The lender gives you the cash and tells you to come back in seven days to repay the balance plus a fee of $45.

When you get your paycheck, you can’t pay the $345 back because you need the money to keep up with expenses. The payday lender offers you a rollover: You can get an extension but have to pay a renewal fee of $45. In the end, you owe $90 for borrowing $300 for a couple weeks. If you can’t pay $390 the next time around, the cycle continues. And if you fail to repay the loan on time, you may owe a late fee, too.

Because the cost to borrow payday loans is so high, it’s easy to get stuck in a cycle of debt.

Takeaway

A payday loan can be like a Ferris wheel that never stops…

When you get on a Ferris wheel, you expect to have a fun time going around once or twice. But imagine you realize the door to your car is locked, and you can’t get out. Similarly, a payday loan can seem useful at first, but you may quickly realize that it’s very expensive, and you're now trapped in a cycle of debt.

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What is a payday loan?

A payday loan is a short-term, expensive loan, designed to help borrowers cover expenses until they get their next paychecks. Typically, the loans have low borrowing limits and high interest rates and fees, making them a last resort for most people.

Many people get paid on a regular schedule, such as weekly or every other week. But expenses — whether essential items like groceries or unexpected emergencies — can crop up in between. Payday lenders offer loans that cover this gap for people who don’t have access to more affordable forms of credit.

Payday lenders often target people with minimal financial means. There are many regulations surrounding payday lenders — The precise rules vary from state to state. Typical restrictions include limits on the amounts payday lenders can lend and the interest rates and fees they charge. Some states don’t allow payday lending at all.

Borrowers generally have to repay most payday loans in a single payment two to four weeks after receiving the loan. They may have to return to the lender to make a payment, or they can give the lender a post-dated check or authorization to withdraw the funds electronically.

A typical payday loan with a two-week term charges $15 for each $100 borrowed. That fee is roughly equal to a 400 percent annual percentage rate. Even credit cards, which are among the more expensive borrowing options on the market, tend to charge interest rates between 12 and 30 percent.

What is the purpose of a payday loan?

Payday loans are generally short-term loans for small amounts. As the name implies, they target people who need to cover expenses until they get their next paychecks. If your checking account runs out of cash, and you don’t have a savings account or emergency fund, payday loans are one way to pay for necessities like groceries or medicine.

Paydays loans aren’t for more substantial expenses or long-term borrowing. The typical borrowing limit is $500, and most lenders expect you to repay the loan on your next payday.

People who need to borrow money for a significant expense or a longer time period often consider a mortgage, auto, small business, or personal loan instead.

How do payday loans work?

Payday loans work differently from typical loans because they have short terms and tend to rely on fees more than interest charges to produce revenue for the lender.

You can apply for a payday loan online or by visiting a brick-and-mortar lender, depending on the laws in your state. You’ll have to supply information, like the amount that you want to borrow, and submit pay stubs to demonstrate how much you make and your payment schedule. Unlike other loans, payday lenders generally don’t consider whether you can repay the loan given your other debts.

Once you’re approved, some lenders will have you provide a signed, post-dated check for the amount you’ll owe. Others will ask you for bank details so they can withdraw the amount electronically. Many states set a limit of $10 to $30 in fees per $100 borrowed. On your payday, the lender cashes your check (or debits your account) in the amount of the loan plus interest and fees.

Sometimes, borrowers can’t repay the money because their expenses continue to exceed their income. If this happens, the borrower could fall into a trap: opting for expensive rollovers, encountering hefty late fees, or using new payday loans to pay old ones.

For example, someone who borrows $400 for two weeks will have to repay $460, assuming fees of $15 per $100 borrowed. If the person can’t repay that amount, he or she will need to borrow $460 and have to repay $529 two weeks after that. If the borrower keeps taking out new loans to pay old ones, he or she will wind up with debts of $608, $670, $805, and so on.

Eventually, the debt can become insurmountable.

What are the requirements to qualify for a payday loan?

Because payday lenders use your regular paycheck as the basis for making a loan, many don’t check your credit history when making a lending decision.

Instead, the typical lender has the following requirements:

  • Borrowers must show ID proving they’re at least 18 years old
  • Borrowers must have an active bank, credit union, or prepaid card account
  • Borrowers must provide proof of income, whether from a job or another source

The exact requirements can vary from lender to lender or state to state.

Do you need good credit for a payday loan?

Most payday lenders don’t require that you have good credit, or any credit history at all. Most won’t pull your credit report when you apply. Instead, they’ll make the loan based on your pay stubs or secure it with a signed, post-dated check.

Keep in mind that payday loans might not report your payments to credit bureaus. That means that a payday loan won’t necessarily help you build credit, even if you are on top of making payments.

On the other hand, if you miss payments, payday lenders may send your account to collections, which hurts your credit.

What is the interest rate on payday loans?

Payday loans generally charge interest rates and fees far higher than any other type of loan. The Consumer Financial Protection Bureau estimates that the average payday lender charges $15 in fees for each $100 that you borrow, with typical prices ranging from $10 to $30 per $100 borrowed.

A fee of $15 per $100 borrowed, assuming a two-week repayment period, is equivalent to a loan with a 400 percent annual percentage rate (APR). This is more than 10 times higher than the rates charged on credit cards, which are among the most expensive ways to borrow money.

What are the disadvantages of payday loans?

There are many drawbacks to payday loans, which is why many people consider them a last resort.

One is their high cost. Payday loans come with fees and interest rates that can give them the equivalent of a 400 percent annual percentage rate or beyond. This is far more than typical loans and credit cards charge, making them one of the most expensive ways to borrow money.

The cost of payday loans makes it easy for people to fall into a cycle of debt, using new payday loans to repay old ones or paying fees for rollovers or late payments. Eventually, they wind up in such large amounts of debt that they can’t cover their payments with new loans.

Payday loans also won’t help your credit. Most lenders won’t report your payments to credit bureaus unless you fail to repay the loan. That means payday loans can only hurt your credit.

What are alternatives to payday loans?

The alternatives to payday loans vary with your financial situation and your reason for applying for a loan.

If you have savings to cover an expense, it may be a good idea to use that instead of borrowing. If you don’t have cash squirreled away, a common alternative is using a credit card. Credit cards are an expensive way to borrow money, but they’re far cheaper than payday loans. If you have to borrow money, a credit card may be preferable to a payday loan.

If you’re using your payday loan to pay an unexpected charge, like a medical or car repair bill, try setting up a payment plan with the provider. It might be willing to work with you, and you’ll probably save money compared to a payday loan.

If you have solid credit, you can try applying for a personal loan (a flexible, unsecured loan through a traditional bank or lender). Even those with okay credit can qualify, but better credit is likely to make the loan cheaper. Personal loans tend to have lower costs and higher borrowing limits than payday loans. As of April 2020, the average personal loan charged around 11 percent in interest. You can also try turning to family and friends for help, or asking your employer for an advance on your paycheck.

Ideally, you can try to build an emergency fund that covers three to six months of living expenses by setting aside some of your income each month. If you can tap an emergency fund instead of borrowing, you’ll save money on interest and fees in the long run.

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