How Do Payday Loans Work?
8 Min Read
According to the Consumer Financial Protection Bureau, approximately 12 million US consumers take out a payday loan at least once per year. The global payday market was worth about $33.5 billion in 2021, and experts expect it to reach $42.6 billion by 2028. Clearly, payday loans are a fact of life upon which many consumers rely. This article explains payday loans, how they work, how much they cost, and several alternative ways to borrow money even if you have bad credit.
What Are Payday Loans?
Payday loans are small loans you repay on your next paydate, typically in one to four weeks. These are high-interest loans, but their small size and short duration limit their actual cost.
Payday loans do not require borrowers to have good credit or, indeed, any credit at all. Payday lenders do not check credit nor report payments to the major credit bureaus. This makes it easy to get payday loans despite bad credit, but they cannot help you build credit.
How Do Payday Loans Work?
Payday loans are available from two main venues: brick-and-mortar storefronts and online. They share similar features, eligibility requirements, and costs but operate differently.
Payday Loan Eligibility
Generally, US payday loan borrowers must meet the following eligibility requirements:
- The state you live in must permit payday lending;
- You must be at least 18 years old;
- You must be a US citizen or permanent resident;
- You must provide job and pay information;
- You must provide your Social Security number, the borrower’s bank account info, and phone number;
- You may have to provide your email address;
- You may have to produce pay stubs to establish your income level.
Storefront Payday Lenders
An internet search can quickly locate the storefront payday lenders near you. You must travel to the storefront location to get a payday loan. The first time you apply for a payday loan from a storefront lender will require more time and paperwork than subsequent visits.
When you arrive, you fill out forms describing yourself, your job, wages, bank account, and pay schedule. You also must have suitable documentation, such as a government ID and pay stubs. If your details check out, the lender will let you know how much you can borrow and what it will charge for the loan. After you sign the loan agreement, it will give you the loan proceeds in the form of cash or a check.
You must repay the entire payday loan debt, including the finance charge, by the due date (i.e., your next paydate). Typically, you do so either with a post-dated check you submit when collecting your money or by giving the lender electronic access to withdraw funds from your bank account.
While storefront loans are fast, they are time-consuming, require travel, and carry risks that cause many potential borrowers to turn to online payday lenders.
Online Payday Lenders
You can get an online payday loan from the comfort and safety of your home (or any place with an internet connection.) Typically, you use a lender-finding network to prequalify your loan and connect you to one or more direct lenders.
You begin by submitting an online loan request to the lending network, which will prequalify your eligibility. It then circulates your request to its lending partners and provides you with one or more links to interested lenders. You can then complete the application process on the direct lender’s website, e-sign the loan agreement, and collect your loan in your bank account as soon as the next business day.
The lender will automatically withdraw your repayment from your bank account on the due date.
What Does a Payday Loan Cost?
Depending on state laws, payday loan annual percentage rates (APRs) may range from 300% to more than 600%. Currently, 16 states and the District of Columbia prohibit payday loans.
Payday loan interest rates are high because they do not rely on credit checks, increasing the payday lenders’ default risk. Thankfully, these loans are small and short-term, limiting their total cost.
Payday loan interest takes the form of a finance charge. You pay the fee when you repay the loan. For example, suppose you take a $225 payday loan with a 14-day term. If the lender charges a $40 finance charge (equal to a 463.49% APR), you must repay $265 on the due date.
What If Borrowers Can’t Repay Payday Loans On Time?
You have a few alternatives when you cannot repay your payday loan on time. The usual course of action is to roll over the loan, but more drastic responses are available.
Payday Loan Rollovers
If you can’t meet the loan’s deadline, the lender will roll over the loan, subject to state law. The steps in a rollover are:
- The lender adds the original finance charge to your loan principal;
- The lender calculates the new finance charge;
- The loan payment due date resets to your next payday.
For example, if you cannot repay the example $225 payday loan by the 14-day deadline, your new principal becomes $225 + $40, or $265. Your new finance charge of $47.11 is based on a 463.49% APR applied to the new loan amount for 14 days. You now owe $312.11 that you must repay on the next due date.
As you can see, rollovers can rapidly get out of control, resulting in a debt spiral that may force you into personal bankruptcy.
Some states regulate payday rollovers, limiting their frequency and timing. This may cause a payday lender to send your overdue loan into collection. The collection agency becomes responsible for recouping the borrowed amount. Although subject to federal regulations, loan collectors are often aggressive and intrusive. If you can’t work out an arrangement with the agency, you may face a lawsuit and possible bankruptcy proceedings.
If you chronically have problems repaying your loans, consider hiring a nonprofit credit counselor to arrange a debt consolidation loan. The new debt is an installment loan whose proceeds repay your existing loans. You then must make just one monthly payment. By setting a long term (typically up to five years), you can make the monthly payments affordable. Although consolidation loans usually have APRs significantly below those of payday loans, they may cost much more in the long run.
Debt settlement is a process that pressures creditors to forgive or restructure your debts. Typically, you hire a debt settlement company that redirects your regular loan payments into an escrow account. The settlement agent then asks your unsecured lenders and credit card issuers to reduce your debt, lower your interest payments, provide a payment holiday, and/or extend the loan repayment schedule.
Short of bankruptcy, this is the only alternative that may reduce your debt. It is risky because creditors may ignore your demands and file lawsuits instead. Normally, a settlement company collects a substantial portion of forgiven debt, reducing the total relief you’ll receive.
Payday Loan Alternatives
Consider these payday loan alternatives if you’d prefer another way to borrow:
Payday Alternative Loans (PALs): Federal credit unions offer PALs to their members as an affordable replacement for a payday loan. You can borrow up to $2,000 for up to a year at an APR capped at 28%. You repay in monthly installments, and loan fees are minimal.
Personal Loans: A personal loan is another type of installment loan with terms ranging from three months to five years or longer. Usually, these loans are unsecured and charge interest rates below 36%. Unlike the payday variety, personal loans check your credit report and allow borrowers to build credit. The amount you can borrow, APR, monthly payment amount, and loan duration depend on your credit score and ability to repay.
Credit Card Cash Advance: Most credit cards allow you to withdraw cash from your credit line at a bank branch or ATM. The advance’s available amount and interest rate (usually below 36%) may differ from those for purchases. These loans do not require you to apply as long as you own a suitable credit card. Card issuers report payments to credit bureaus, allowing you to rebuild your credit. Interest accrues and compounds daily on your unpaid balance.
Cash Advance Apps: You can use a cash advance app for small advances to keep you going until your next paycheck. Amounts available vary from $100 to $500, depending on your wages and ability to repay. Typically, cash advance apps charge little or nothing for their services. You must share access to your bank account and work timesheet to qualify for a cash advance app.
401K Loan: Your workplace 401K plan may allow you to borrow tax-free up to $50,000 or 50% of your balance, whichever is less. But you can borrow up to $10,000 without regard to the percentage. The interest rate is low, and the interest you pay (minus fees) goes back into your balance. The repayment deadline is usually five years. If you fail to repay by the deadline, you must add the unpaid portion to your annual taxable income. This type of loan may take one or two weeks to process. Remember that 401K borrowed funds lose their interest-deferred growth until repaid.
Auto Title Loan: You can apply for an auto title loan if you don’t owe money on your vehicle. These are expensive, short-term loans collateralized by your car’s title. They require no credit checks and feature APRs roughly equal to those for payday loans. Typically, you can borrow up to 50% of your car’s value through a title loan. Remember that the lender can seize your vehicle if you fail to repay the loan on time. You cannot build credit with an auto title loan.
Loans from Friends and Family: You may be able to arrange a loan on favorable terms from a friend or family member. The lender may waive interest and a definite due date. This type of loan is attractive but may strain your relationship with the lender if you fail to repay. The safest procedure is to draw up and sign a promissory note specifying the loan’s terms and conditions.
Borrow With a Payday Loan
Many consumers turn to payday loans when they need a modest amount of fast cash to tide them over until their next paycheck. The easiest way to obtain one is through an online lending network. With any type of loan, ensure you understand its terms and conditions before accepting it. You never want a loan to hand you a surprise because you didn’t carefully review the lending agreement.
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