What is a payday loan and how does it work?

Life has a way of throwing curveballs when we least expect them. In those moments when you're staring at an empty bank account, everything can feel very hard. It’s a brilliant move to do a little bit of research into what payday loans are so that you can make a more informed decision about whether to get one. 

You’re not alone in this—millions of people face these same challenges. Even when things feel desperate, you might have more choices than you realize. It may be tempting to reach for the first solution that promises quick cash, but doing so could put you farther behind financially than you are now. Let's explore what you need to know about payday loans.

What is a payday loan? 

A payday loan is a short-term loan that is typically repaid within two to four weeks. The due date is your next payday. 

Payday loans work much differently than any other loan type. There are even special laws that regulate them in an attempt to help people because they’re often considered a type of predatory loan. Predatory means the terms are abusive to you, the borrower. To learn why, let’s look at how they work. 

Here are some of the key characteristics of a payday loan:

• Unsecured. Payday loans don’t require collateral, meaning you don't need to put up anything of value as security for the loan. 

• High interest rates. Payday loan annual percentage rates (APRs) are often 100% to 400%. The average is 372%, and they’ve been known to go higher. This is far more than you’d pay for a loan from a bank, credit union, or most other loan sources.

• Small loan amounts. A standard loan limit for a payday loan is $500, although some states may allow for larger amounts. Borrowers are expected to repay their loans by the time their next paycheck arrives, so keeping loan amounts low makes sense. 

• Pre-authorize payment. A payday lender will generally require you to write a post-dated check for the full balance of the loan, including fees. Or they may ask you to authorize an electronic debit of the funds from the bank account where you get your direct deposit. If you fail to repay the loan on or before the due date, the payday lender can cash the check or withdraw the money from your account. Note that a lender can make only two attempts to take money from your account. 

• Potential debt trap. Payday loan fees typically range from $10 to $30 for every $100 borrowed, making them one of the most expensive ways to borrow money. 

How do payday loans work? 

If payday loans are available in your state, here's a step-by-step breakdown of how they work: 

• Apply for the loan. The lender checks your ID and proof of employment. They’ll also make sure you’re eligible for the loan under your state’s laws.

• Sign the agreement. You sign disclosures and other contracts related to the loan. 

• Pre-authorize repayment. You’ll be required to sign and leave a post-dated check, or authorize the lender to withdraw money from your bank account on your next payday. 

• Receive funds. Depending on the lender, you might leave a storefront location with a check, prepaid debit card, or physical cash. They may deposit the loan funds directly into your bank account. 

• Repay the loan. If you do nothing, the lender will process a full repayment of the loan, plus any applicable fees on the due date. 

What if you can’t afford to repay the full amount on payday? Most borrowers (more than 80%) can’t. In that case, you might have the option to roll over your current payday loan into a new one. You pay the fees now, and again on your new due date. 

Each state has laws governing payday loans, and several prohibit payday lending altogether. Some states set strict limits on the fees payday lenders can charge. Payday lenders typically don’t operate in states with strict interest rate caps.

Who qualifies for a payday loan? 

Payday lenders don’t run credit checks, so your credit score is never an issue. To qualify for a loan, payday lenders generally require you to be at least 18 years old and have:

• An active bank, credit union, or prepaid card account

• Proof of income from a job or other source

• Valid identification 

Anyone meeting these requirements will likely qualify for a payday loan. 

What is true about payday loans? 

Payday loans aren’t your only option. If you've had past issues with debt or your credit score is poor, you might think a payday loan is your only option. Nothing could be further from the truth. 

Credit card cash advances are usually cheaper than payday loans. Let’s say you're moving and learn at the last moment that your moving truck will cost an additional $500. A payday lender isn’t your only option. For a quick $500, consider borrowing from family or friends. If that doesn't work out, consider taking out a cash advance on a credit card. While the interest on cash advances is typically higher than the rate on regular purchases, it's still far less expensive than a payday loan. 

Payday loans can’t help you build credit (but they could hurt you if you default). Unlike traditional lenders, payday lenders typically don’t report to credit reporting agencies, such as Equifax, TransUnion, or Experian. Even if you repay your loan in full by the due date, it won't improve your credit score. However, if a payday loan goes to collections, the debt collector is likely to report it to the credit bureaus.

What are the biggest risks of payday loans? 

Payday loans come with risks. The biggest ones are as follows.

APRs often exceed 400%

Like all lenders, payday lenders must disclose upfront their fee equates to an APR. For example, a $100 payday loan with a $15 fee due in two weeks equates to an APR of 391%. This rate is astronomical. 

As a comparison, credit card APRs typically range from about 8% to about 36%. A payday loan would actually be 17 times more expensive than using a credit card.

You wouldn’t take out a credit card with a 400% APR. But because payday loan lenders hide the true cost behind fees, it’s easier for them to get away with charging you more. 

Getting trapped in a debt cycle 

Payday loans make it easy to land in a debt trap. The very short term means most borrowers won’t be able to pay their other important expenses and still pay back the loan. 

More than four out of five payday loan borrowers are forced to re-borrow the money within a month. They get caught up in a cycle of paying more and more fees. About half of borrowers borrow more than 10 times a year, paying more in fees than they ever received in loan money. 

Bank fees

Some online payday loan borrowers end up paying an average of $185 in bank fees to their own bank. That’s because the payday lender made one or more failed automatic attempts to collect the debt from their account. About a third of payday loan borrowers end up having their bank account closed. 

Are payday loans worth it? 

An emergency is an emergency, and if you don't have access to funds, there may be times when a payday loan seems like your only option. 

Payday loans are never a preferred solution, but life can be messy. Before taking out a payday loan, make sure you've exhausted all other options. 

Due to the APR and steep fees, payday loans are never worth it to pay for things you can live without. Say there's a fabulous sale at your favorite clothing store, or you've been offered a pair of World Series tickets at a bargain price. No matter how great a deal you get, the exorbitant fees associated with a payday loan will eat up the savings. 

Millions of people have turned to payday loans to get through a rough patch, and there's no shame in that. This is an expensive world we live in. However, the goal is to have alternatives to payday loans tucked away in your back pocket so you're ready the next time you hit a bump in the road. 

What are better alternatives to payday loans?

Payday loans aren't great, but what about your other options? Check out the following list, but look now (before you urgently need money): 

• Payday alternative loan. A short-term, affordable loan available from some credit unions with fewer requirements. You usually need to have been a member for at least one month before you’re eligible for this loan. 

• Personal hardship loan. Your employer might offer a hardship loan or you could explore what happens if you take out a hardship withdrawal from your 401(k). 

• Cash advance apps. Some apps offer short-term loans at an affordable fee (sometimes even free). You would need to set up the app in advance. Once you do, you may be able to get same-day cash the next time you need it.

• Pay bills late. A common reason for taking out a payday loan is to pay a bill that has come due. Even if you have to pay a late fee, it’ll probably cost less than a payday loan. Let's say you have an electric bill that needs to be paid. Give the company a call, explain your situation, and ask them to make a note that you called. If nothing else, you're approaching them in good faith.  

• Charity and government help. Call or visit 211.org to see if you’re eligible for any financial programs or support in your area. 211.org is free, confidential, and available 24/7, 365 days a year. The organization is designed to help you find local resources that meet your specific needs. 

If your struggles are expected to last, here are some solutions you could implement for the long term:

• Credit counseling. A nonprofit credit counselor could help you figure out  your budget and make a good financial plan. Credit counseling is often free or very affordable.

• Debt resolution. If you have a hardship and can’t afford to repay your debts, consider debt resolution. That’s when you negotiate with your creditor and get them to agree to accept less than the amount you owe. The rest is forgiven. You can negotiate debts yourself or work with a professional debt resolution company. This won’t help you get cash immediately, though.

What's next? 

Most people face financial hurdles at some point. You can’t change the past, but you can use challenging experiences to shape your plans for the future. 

The first step is to get control of the situation. If you're considering a payday loan because you're in debt and can’t save money for a rainy day, explore the resources available to you. Call 211 and talk to a debt expert. Also, have a conversation with trusted family members or friends. There could be someone in your life who has the ability and willingness to help.