Payday Loans: How Do They Work & What Do You Risk

Payday loans are a type of short-term loan. The loans, which are for small amounts, often $500 or less, are designed to be paid back when you get your next paycheck.

While they evolved from criminal “salary lending” practices in the early 20th century, these loans really took off in the 1990s, when there were few small loan lenders. The shortage is sometimes blamed on banking deregulation in the 1970s and 1980s, especially the proliferation of state exemptions from “usury caps,” which had limited the maximum annual percentage rate (APR) for single repayment loans. Today, the bulk of these loans are taken out to cover rent or similar repeat expenses, with as much as 80% of them being “renewed or quickly reborrowed,” according to the nonprofit Pew Charitable Trusts.

The loans are notorious as an expensive way to acquire money. Consumer advocates worry that they perpetuate debt cycles.

How do payday loans work?

With a payday loan, you are paying to borrow money for a short time. To take one out, you’d go to a payday lender, either in person or online, that offers a loan for a fee. The loans usually last for a set number of weeks, and in many states they are limited to less than a month. When the term is up, the loan and the fees are due.

The most common forms of collateral are for the borrower to write a post-dated check for the loan and relevant fees or to authorize the loan provider to electronically debit the funds. The check or debit would include the amount of the loan plus the associated fees. If you don’t pay the lender back by the agreed-upon date, the check will be cashed or the funds debited.

Risks of Payday Loans: What You Should Consider

With the majority of Americans ill-equipped to handle unexpected expenses, observers warn that payday loans make poor substitutes for safer loans. What’s the concern? Payday loans are most often used as a frantic solution when cash runs out, which is why they have high interest rates and fees. The unfortunate result is that most people who take out a payday loan pay back considerably more than they borrowed.

Worse, these loans can lead to what are called “debt traps,” where cash emergencies turn into cycles of ruinous debt. Say, for instance, you take out a payday loan to help cover rent, and when the amount is taken from your next paycheck, you are forced to borrow again against future wages to pay the next month’s rent. The sequence just repeats and repeats.

Once that cycle has hooked you, it can take some time to dig yourself out. The average payday borrower spends five months of the year in debt and pays $520 in fees to borrow, according to Pew Charitable Trusts. This concern, among others, has led to payday loans being more tightly regulated in several states in recent years. Only 37 states allow payday loans, with 15 of those limiting the amount you can take out to $500 or less.

Payday loans are predatory in nature, designed to exploit weakness. They often target low-income earners, minorities, the less-educated, and the elderly, according to the National Association of Consumer Advocates.

How much do payday loans cost?

The cost of a payday loan is regulated and differs from place to place. For most loans lenders demand a fee ranging from $10 to $30 for every $100 borrowed, according to the U.S. Federal Trade Commission (FTC). If you were to take out the maximum in California of $300, that would mean fees somewhere between $30 and $90. There may be additional fees, such as a fee to renew the loan if you have to delay repayment.

What Are Payday Loan Interest Rates?

For the typical payday loan, the cost of borrowing will run much higher than alternatives. The FTC estimates that the average two-week payday loan carries a 391% APR.

That staggeringly high number makes these loans far more costly than credit cards or other personal loans. The FTC says that the average credit card had an APR of just under 21% in the first quarter of 2023. Such a difference should ring alarm bells with everyone, not just consumer advocates.

Do payday loans build credit?

You don’t need a strong credit score to get a payday loan, so might paying one back help you build your credit?

The answer, alas, is no, because lenders that offer payday loans usually don’t report payment details to the three main credit bureaus that compile your scores. If the bureaus don’t know about your payment, your credit scores can’t improve.

Moreover, under some circumstances payday loans may actually lower your credit scores by triggering loan defaults, thus engendering debt collections.

What do I need for a payday loan?

Payday loans are easy to acquire. You only need proof of income—usually in the form of recent pay stubs—an ID, and a bank account. Your credit score doesn’t matter very much, if at all, as these loans cater to those who are strapped for cash.

What happens if I can't repay a payday loan?

When you take out a payday loan you are expected to pay it back during a fixed term, usually when you get your next paycheck. Indeed, some states limit the repayment terms to within a month.

What if the deadline arrives and you can’t pay? This is when lenders allow you to renew the loan in what is known as a rollover, where you pay another fee to delay repayment of the loan. Of course, this adds to what you must pay for borrowing the money.

Missing payment might have another consequence. If you repeatedly fail to repay a loan, the lender may decide to pass on your debt to a collector This is likely to be reported to the three main credit bureaus, causing your credit scores to plummet.

Payday loan alternatives to consider

There are lower-cost alternatives to payday loans, although these also have complications.

Borrowing from relatives or friends

Obviously, this gambit is dependent on your relationship dynamics—and how affluent the people in your network are. Borrowing money from those you care about can be emotionally fraught. On the other hand, caring is a two-way street, and family and friends may be able and willing to help in a tight spot. They are certainly unlikely to charge you the high interest rates and fees that come with a payday loan.

If you go this route, be sure to put the agreement in writing and live up to it impeccably. Think of it in the same way you would think of any legal loan agreement. Don’t succumb to the temptation that you can let paying it back slide because you are dealing with people who will just give you a pass. If they would, they would have gifted you the money, not lent it.

Taking out a personal loan

A personal loan is preferable to a payday loan because the interest rate is invariably lower and the term is usually longer. However, as a personal loan is generally secured through a financial institution, such as a bank or credit union, your ability to get one will likely hinge on having an acceptable credit score. Before giving up, though, you should check out personal loans that are designed specifically for those with bad credit.

TIME Stamp: Payday loans are predatory and should be avoided if at all possible

A payday loan should only be taken out as a very last resort. While easy to get, it’s extremely expensive and can quickly dig you into an even deeper financial hole. There are alternatives, and you should exhaust them all before taking such a drastic step.

Frequently asked questions (FAQs)

Are payday loans legal?

Yes, but only in some states. They operate under regulations and, in recent years, have been more strictly scrutinized.

For example, according to a regulation tracker from the National Conference of State Legislatures, a bipartisan research organization, in California, the most populated state in the country, payday loans can’t exceed $300 and have a maximum repayment window of 31 calendar days. By contrast, Delaware sets the maximum loan amount at $1,000 and the repayment window at less than 60 days.

Why should you avoid payday loans?

The biggest problem with payday loans is that you are paying a lot to borrow money for only a short period. You may not have the time to acquire enough cash to pay one back, and the high fees can quickly add up, especially if you’re taking out multiple loans. They can all too easily create a self-perpetuating debt trap from which it is very hard to emerge.

Are payday loans hard to pay back?

Yes, because most payday borrowing happens for repeat expenses. You will almost certainly need to find a source of extra income to avoid rolling over the loan repeatedly, accruing more in interest each time.