As many as 78% of adults in the U.S. report living paycheck to paycheck. And when money runs out before the next paycheck comes in, many people turn to payday loans to cover unmanageable or unexpected costs.
Payday loans are high-interest, short-term loans, usually for $500 or less. They’re essentially cash-advance loans intended to bridge the gap between paychecks. So you take out the loan and pay it back your next pay day. Payments are made using post-dated checks for the original loan, interest—at an annual percentage rate of up to 400%—and fees or through automatic withdrawals from your bank account.
Unfortunately, many people get trapped into extending a payday loan and paying higher and higher costs in added interest and fees. A Consumer Federal Protection Bureau (CFPB) study found that 80% of payday loans are extended past the original repayment date.
The payday lending trap, as it is known, is so prevalent that the CFPB proposed a regulation to protect consumers from spiraling payday loan fees and interest when loans are renewed. At publishing time, the agency hadn’t yet enacted the regulation, however.
Before you settle on a payday loan, take time to learn about what they are, how they work and what other options there are that might be more beneficial for you.
The benefits of payday loans include fast access to necessary cash and the ability to get one with no credit check. The downside is that payday loans are much more expensive than payday loan alternatives.
How Payday Loans Work
Typical payday loan terms require full repayment within two weeks or one month. An example of how a payday loan works, looks like this:
- You borrow $400 to cover an unexpected car repair
- The finance charge for borrowing the money is $15 for every $100, or $60 total—so you need to pay back a total of $460. This is an example, and finance charges and terms on payday loans vary by lender, borrower and state.
- The terms require that you repay the loan over the following two weeks.
- You make two weekly payments of $230 each or one total payment of $460 when you get your next paycheck.
- If you don’t pay the money back as agreed, or if your post-dated check or automatic electronic payment is returned for insufficient funds, the payday lender charges additional fees, making the loan even more expensive.
Some payday lenders let you roll a loan over to the next payday or month. But a rollover comes with another finance charge or fee. What you’re really doing is taking out another payday loan to cover the total amount you owe to the lender.
In the example above, a rollover of the original loan might look like this:
- You owe $460 to the payday lender.
- You choose to roll over the loan for another fee of $60.
- Now you owe the payday lender $520.
When you do the math, a $60 finance charge for a two-week loan equates to a 391% annual percentage rate (APR). Start adding in rollovers, and you end up paying hundreds of dollars in charges.
Applying for and Getting Approved for a Payday Loan
Payday loan requirements vary depending on the lender and state where you live. Each state has different rules about who can apply and the fees payday lenders can charge. Some states have either banned payday loans completely or put strict limits on them with usury laws. Usury laws are legislation that mandates how much interest can be charged on loans to protect consumers from creditors who might charge unacceptably high APR.
If you live in a state that doesn’t allow payday loans or restricts them, you might still be approved for this type of loan. Sometimes, loan providers work with out-of-state banks to get around legislation. Read the fine print of your agreement and understand which bank is actually funding your loan.
While some states require that payday lenders evaluate whether or not someone seems to have the financial ability to pay back a loan, the vast majority of payday lenders don’t pull your credit history. Instead, minimum requirements for getting approved tend to include:
- Being old enough—the rule is 18 years or older in most states
- Valid contact information, which might include a phone number, mailing address and email address
- A checking account that’s open and active—the account is used to receive deposited funds from the payday lender and to make payment arrangements on the loan
- Proof of income, including paystubs or a W2 form—payday lenders typically want to see one to three recent pay stubs that show what you make
You can apply for payday loans in person or online. The process of applying online typically takes 5 to 10 minutes. Approval decisions are almost instantaneous. Common online payday loan application processes include:
- Completing a short form that includes providing your name, address, phone number and a few other pieces of identifying information, such as your date of birth
- Entering your income information and uploading backup information, such as PDFs of your paycheck stubs
- Entering your bank routing number and checking account information
- Choosing a loan amount and terms from the lender’s options
- Waiting for a response, which can take a few seconds or a few minutes
- Agreeing to the terms of the loan and payment arrangements
If the loan is approved and you agree to the terms, the payday lender electronically deposits the money into your checking account. Depending on your bank’s processes for handling electronic funds transfers, you can access the money in one to three business days.
If you use a local lender with a physical storefront, you can receive the money on the spot in the form of cash or a physical check.
The Payday Loan Trap and How to Avoid It
The payday loan trap occurs when you are caught in a borrowing cycle you can’t break. When trapped, you keep using payday loans as long-term loans rather than as short-term loans for financial surprises.
Consider the emergency car repair example. Here’s one way it can turn into a payday loan trap.
- You borrowed $400 and now owe $460.
- You make $1,000 on payday, but your rent is also due, and life itself comes with throw expenses, such as groceries, gas and utilities, at you.
- You can’t afford to pay the loan this payday, so you roll it over, and now you owe $520.
- Between now and your next payday, the air conditioner breaks and you pay to repair it, which means you can’t pay the total payday loan next payday either.
- You roll the loan over again for a fee of $75. Now you owe $595—more than half your paycheck. And the rent is due again.
You can see how the payday loan trap happened quickly and the cycle keeps getting more expensive every few weeks. Even if you can repay some of the money you owe on the loan, your loan keeps getting more and more expensive.
If you pay, say $50 a month toward your original $400 payday loan, at the end of a year, you still owe $526. You’ve paid almost 391% APR and are still in debt for more than $500.
And if you fail to repay the loan, the lender might turn you over to a collection agency. While payday lenders don’t report to the credit bureaus, the collection agency will report your default on the loan to bureaus. And then, your payday loan trap hurts your credit score.
If you’re already trapped in a payday loan, there’s hope. Credit cards, personal loans, credit counseling, payment extensions and different types of financing are all ways to escape the payday loan trap.
Alternatives to Payday Loans
The true cost of payday loans, especially in relation to the costs of alternatives, is hard to understand. In the example above, $60 may not seem like a huge cost, especially when the alternative is a car that won’t get you to the job you need. If you can pay it back on time, maybe that’s okay. It’s when you can’t that you need to worry. Those so-called finance charges are just a different way of charging interest.
In contrast, a personal loan charges an APR that’s much lower than the costs on a payday loan. Personal loan APRs tend to be between 10% and 30%, and they almost always have more favorable repayment terms—three-plus years compared to two weeks. Typically, you make smaller monthly payments over a longer period of time on these loans, which makes it easier to avoid the trap described above.
The interest on a personal loan doesn’t compound. You simply make a consistent monthly payment over the life of the loan. And if you can pay a small personal loan off quickly, as you’re supposed to do with a payday loan, the lower APR means you save a lot in interest.
Say you have poor credit and take out a personal loan for $400 at an APR of 94.5% for one year. You pay roughly $53 a month and total interest of $232.82 for a total cost of $632.82. Pay a fee of $60 a month for a payday loan and you hit that $232.82 in interest in 4 months.
Similarly, credit cards offer lower APRs than payday loans with interest rates that range from 13% to 30%. It’s easy to end up with excessive credit card debt if you don’t make more than your minimum monthly payment though. But, you always have the option of making more than the minimum monthly payment.
Say you put that $400 on a credit card. For simplicity, it’s the only balance on your card. Your minimum monthly payment might be $8 if your card issuer charges 2% of the balance for your monthly payment, $25 if they default to a $25 minimum payment.
If you pay the $8, you then pay interest on the carried over balance of $392. Your card’s APR is 26.24%. That interest is a periodic daily rate and equals only $8.45 in interest. That’s much less than on a payday loan where you pay $15 or more for each $100 left or more for a minimum total of $60.
If cash flow is slow or nonexistent and you need access to funds to cover emergency or unplanned expenses, consolidate existing debt or handle other obligations, consider an alternative to a payday loan. If you choose the alternative of a personal loan or credit card instead of a payday loan, you can apply for a personal loan or credit card on Credit.com.