What is a payday loan and how does it work?

It’s a smart money move to learn about your loan options before you need to borrow. That’s especially true of payday loans. Even if you’ve taken out a payday loan before, there’s plenty to learn to help you manage your cash more smoothly. 

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. 

What is a payday loan? Here’s a simple definition

You probably know a payday loan when you see it, but it helps to get a view of the larger picture. Most payday loans share the same characteristics:

• Cost: $10 to $30 for every $100 you borrow. 

• Amount: $100 to $1,000.

• Term length: Repaid in full out of your next paycheck, within two to four weeks.

• Credit check: No credit check.

• Requirements: Must have a bank account, identification, and steady income. 

How do payday loans work?

Payday loans work differently depending on which state you live in. That’s because each state has laws governing payday loans, often setting limits on how much payday lenders can charge. In some states, these consumer protection laws may be so strong that you won’t see payday lenders there at all. 

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

1. You apply for the loan: The lender checks your ID and proof of employment, and makes sure you’re eligible for the loan under your state’s laws.

2. You sign the agreement: You sign disclosures and agreements for the loan. You may be required to sign and leave a post-dated check with the lender, or authorize them to withdraw the payment digitally from your bank account on your next payday. 

3. You receive funds: Depending on the lender, you might leave a storefront location with a check, prepaid debit card, or physical cash. Or they may deposit the loan funds directly into your bank account. 

4. You repay the loan: If you do nothing, the lender processes your repayment of the loan in full, plus fees. Depending on where you live, you may have an option to roll over your current payday loan into a new one (for even more fees, of course), or sign up for a payment plan to repay it over three or more months.

How much does a payday loan cost?

One of the biggest downsides of payday loans is their cost. Payday loans generally list their cost in terms of a single fee—usually between $10 and $30 for every $100 you borrow. It doesn’t sound like much, but here’s a key question: if you’re offered a two-week payday loan charging a $15 fee for every $100 you borrow, what is the loan’s interest rate?

That is a really common payday loan fee. And when you do the math, it works out to an annual percentage rate (APR) of nearly 400%. 

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. 

Here, too, your state’s laws have a big say in how much you pay. According to a recent Pew study, the average APR for a payday loan ranged from 114% in Colorado to 652% in Idaho.

Why are payday loans bad?

It’s wise to avoid payday loans because they are so expensive it can be very difficult to pay them off. 

If you live in Idaho and take out a $1,000 payday loan, for example, that means you pay a financing fee of $250. So, at your next payday, you’ll have a total of $1,250 less after you pay back the loan: the $1,000 you borrowed, plus the $250 fee. If you were already having trouble making ends meet, it’s unlikely that it’ll be easier in your next paycheck cycle with even less money. 

And that brings us to the next big downside of payday loans: it’s easy to get caught in a cycle of debt. 

Lenders often allow you to “roll over” your payday loan into a new one if you can’t pay it back when it’s due. So now, you’re paying two sets of fees on the amount you first borrowed. 

About 80% of borrowers roll their payday loans over, according to one study from the Consumer Financial Protection Bureau. About 15% of people roll over their payday loans nine times before finally paying it off. 

By that point, There’s a good chance that your fees have grown even larger than the amount you originally borrowed, making for a very expensive loan indeed. That makes it even harder to get ahead in all areas of your financial life, including saving for emergencies. 

Alternatives to payday loans: Where can you get money fast?

So, payday loans aren’t great. But what are your other options? Check out these options, but do so 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. 

• Cash advance apps: Some apps offer short-term loans for an affordable fee, although they tend to be for smaller amounts than payday loans. 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.

• Credit counseling: Get a referral from the National Foundation for Credit Counseling to have someone walk you through your budget, identify problem areas, and develop a plan. 

• Charity and government help: Call or visit 211.org to see if you’re eligible for any financial programs or support in your are. 

How to break the paycheck-to-paycheck cycle

Dealing with payday loans is stressful, but you can pave the way to stress-free finances—for good—by making some small changes that steer you toward long-term benefits:

• Find a budget style that works for you.

• Use a money management app to stay on top of your spending.

• Look for ways to increase your income and cut expenses. 

• Don’t borrow money unless you absolutely need something.

• Use a credit builder loan or secured credit card to start building credit.

• Follow some personal finance bloggers who resonate with you.

• Set up a small savings goal for a $500 emergency fund—and work up from there.

• Pay down your credit card debt, then try not to carry a balance from month to month. Use an easy debt paydown app to help you.