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What Is a Payday Loan? How It Works, Obtaining One, and Legal Aspects

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What Is a Payday Loan?

Payday loans are high-cost, short-term loans for relatively small amounts of money, usually $500 or less, that are meant to be repaid with the borrower's next paycheck. They are designed to be a quick and easy solution for unexpected expenses or to bridge a short-term cash flow gap.

To obtain a payday loan, you typically need to have a bank account and provide proof of income, such as pay stubs from your employer. You also need to provide a post-dated check or access to your bank account for the lender to collect repayment. Payday loans usually don't require a traditional credit check.

Key Takeaways

  • Payday loans are short-term, very-high-interest loans available to consumers.
  • To obtain a payday loan, you typically need to have a bank account and provide proof of income. You'll also need to provide a post-dated check or access to your bank account for repayment.
  • Payday loans are typically based on how much you earn, and you usually have to provide a pay stub when applying for one.
  • Payday loans are not available in all states. Sixteen states—Arizona, Arkansas, Colorado, Connecticut, Georgia, Maryland, Massachusetts, Montana, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, South Dakota, Vermont, and West Virginia—and the District of Columbia outlaw payday loans of any kind.

Understanding a Payday Loan

Payday loans function differently than personal and other consumer loans. Depending on where you live, you can get a payday loan online or through a storefront lender.

Different states have different laws surrounding payday loans, limiting how much you can borrow or how much the lender can charge in interest and fees. Some states prohibit payday loans altogether.

Once you're approved for a payday loan, you may receive cash or a check, or have the money deposited into your bank account. You'll then need to pay back the loan in full plus the finance charge by its due date, which is typically within 14 days or by your next paycheck.

Payday loans come with a finance charge, which is typically based on your loan amount. Because payday loans have such short repayment terms, these costs translate to a steep APR. According to the Consumer Federation of America, payday loan APRs are usually 400% or more.

How Payday Loans Work

Payday loan lenders generally don't assess your ability to repay the loan while meeting your other financial obligations. Instead, they determine your loan amount based on a percentage of your predicted short-term income. Many states regulate the costs of payday loans, limiting how much lenders can charge for the loan.

Here's how payday loans generally work:

  1. You fill out a payday loan application, providing your personal information, proof of income, bank account details, and the amount you want to borrow.
  2. The lender reviews your application and decides whether to approve or deny your request. If approved, the lender will inform you of the loan terms.
  3. You sign a loan agreement or provide authorization for the lender to withdraw the loan amount plus fees and interest from your bank account electronically.
  4. The lender provides the loan funds in cash, with a check, or by depositing the money into your bank account. You'll need to repay the loan amount plus fees and interest by the due date, which is typically your next payday (usually around two weeks later).

If you can't repay the loan on time, the lender can cash your check or electronically debit your account. If your checking account doesn't have sufficient funds, you'll face more fees from your bank plus additional charges from the lender. This can compound your debt quickly.

How to Get a Payday Loan

Payday loan requirements vary from lender to lender and state to state. However, there are some general guidelines that most payday lenders follow.

To qualify for a payday loan, you typically need:

  • An active bank, credit union, or prepaid card account
  • Proof of income, such as a pay stub or benefits check (like Social Security)
  • Valid identification
  • To be at least 18 years old

You provide this information to the payday lender, and they give you a decision on whether they'll lend to you, the amount, and your loan terms. If you agree, you either provide a post-dated check for the full loan amount plus interest and fees or sign an agreement allowing the lender to electronically withdraw the funds on the loan's due date.

Beware of lenders that guarantee you a loan without first checking your ability to repay or that ask you to "guarantee" the loan by providing personal information like your Social Security number or bank account information.

Payday Loan Interest Rates

Payday lenders charge exorbitantly high levels of interest. The fees are so high that borrowing $100 for two weeks can cost you $15 or more in interest. The typical payday loan has an annual percentage rate (APR) of 391% or more, according to the Federal Reserve Bank of St. Louis.

Most states set a cap on the interest rates that can be charged for payday loans, but there are exceptions. Some states, such as Nevada and New Mexico, have no restrictions on payday loan interest rates.

Here are the typical costs of borrowing a payday loan, compared to some other types of loans:

  • Credit cards: 12-30% APR
  • Personal loans from banks: 10-28% APR
  • Credit union personal loans: 8-18% APR
  • Pawnshop loans: 15-240% APR
  • Payday loans: Typically 391-521% APR

How much does a payday loan cost?

The cost of a payday loan varies depending on your state's laws and the amount you borrow. Typically, payday lenders charge a percentage or dollar amount for every $100 borrowed.

Fees range from $10 to $30 per $100 borrowed, which can equate to an APR of nearly 400% for a two-week loan. For instance, if you borrow $300 with a $45 fee, that equates to an APR of 391%.

Moreover, if you extend or "roll over" the loan because you can't pay it off, you'll usually have to pay an additional fee. This can make it very costly to borrow money, especially compared to other options like credit cards, traditional personal loans from a bank or credit union, and loans from friends or family.

Are Payday Loans Legal?

In most states, payday lending is legal. States that don't allow payday lending include:

  • Arizona
  • Arkansas
  • Colorado
  • Connecticut
  • Georgia
  • Maryland
  • Massachusetts
  • Montana
  • New Hampshire
  • New Jersey
  • New York
  • North Carolina
  • Pennsylvania
  • South Dakota
  • Vermont
  • West Virginia
  • District of Columbia

Other states regulate payday loans differently. For example, some cap the number of loans a borrower can take per year, while others require lenders to offer extended repayment plans.

At a federal level, payday lending is subject to several regulations:

  • The Truth in Lending Act requires payday lenders, like other financial institutions, to disclose the cost of borrowing to the borrower. This includes the finance charge and APR.
  • The Military Lending Act provides protections for service members and their dependents. On most types of consumer loans, it caps the interest rate at 36% and prohibits lenders from requiring service members to submit to arbitration instead of taking the case to court.
  • The Consumer Financial Protection Bureau (CFPB) issued a rule in 2017 requiring payday lenders to check a borrower's ability to repay the loan before making the loan. However, in July 2020, the CFPB revoked the mandatory underwriting provisions of the rule.

Check with your state's laws to see if payday loans are regulated or prohibited, and what rules they must abide by.

Are Payday Loans Fixed or Variable?

Payday loans are typically structured to be paid off in one lump-sum payment when you receive your next paycheck. Therefore, the interest rate on these loans is fixed. In fact, many payday lenders don't even express their charges as an interest rate, but rather as a fixed fee per loan amount.

For example, a lender may say that it charges $15 per $100 borrowed. To determine the APR, you'd take that number and then multiply it by the number of times the amount was borrowed in one year. For a $100 payday loan, you'd multiply $15 by 26 two-week periods, resulting in an APR of 390%.

Is a Payday Loan Secured or Unsecured?

Most payday loans are unsecured. This means that you don't have to give the lender any collateral or borrow against a valuable item as you do in a pawn shop.

Instead, the lender will normally ask you for permission to electronically take money out of your bank, credit union, or prepaid card account. Alternatively, the lender may ask you to write a check for the repayment amount, which the lender will cash when the loan is due. Under federal law, lenders cannot condition a payday loan on obtaining an authorization from the consumer for "preauthorized" (recurring) electronic fund transfers.

How Long Do Payday Loans Stay in the System?

The records of traditional loans may be kept for six to 10 years by credit bureaus—the companies that calculate credit scores, which in turn may affect your ability to borrow money in the future.

Payday lenders do not usually report to the credit bureaus, even in case of overdue repayments. But if the loan gets turned over to a collections agency, that agency may report it to a credit bureau, damaging your credit score.

If you do manage to repay your payday loan on time, the record of that loan may remain in your credit file for up to seven years. However, it should not negatively impact your credit score going forward.

How do payday loans affect credit?

In most cases, payday loans won't show up on the credit reports you get from the three major credit reporting bureaus (Experian, Equifax, and TransUnion). However, there are specialty credit reporting agencies that collect information on payday loans.

If you pay your payday loan on time, then your credit score shouldn't be affected. On the other hand, if you default on your loan and your debt is placed in the hands of a collection agency, then you will see a dip in your score.

Eventually, collections agencies may sell the debt to a debt buyer. The debt buyer could choose to file a lawsuit against you. If they win a judgment against you, or you agree to pay the debt, this information may appear on your regular credit report and could lower your credit score.

Can Payday Loan Debt Be Forgiven?

In practice, it's very rare for payday loan debt to be written off. This is because payday lenders make significant sums from the interest that they charge on these loans.

Some payday loan companies may offer options for debt relief or debt settlement, but this typically means you'll be paying more than you originally borrowed. If you can't pay back a payday loan, the account may be sent to a collection agency, which will pursue you for the money and interest that you owe. This is not only unpleasant but also can add money to your overall debt—and it will damage your credit.

Can You Get a Payday Loan Without a Bank Account?

Yes. Having a bank account isn't universally required to borrow money, but lenders that don't require it generally charge high interest rates. This includes many payday lenders. Payday lenders may ask for a bank account, but sometimes a prepaid card account may be enough to qualify.

These loans are often even riskier, as they likely come with high fees and even higher interest rates. Without a bank account, "guaranteed" payday loans are tantamount to predatory lending; these lenders may operate outside of regulations for traditional payday loans and take advantage of people in unfavorable financial situations.

Is my state allowed to ban payday loans?

Each state has the authority to cap interest rates and decide whether to allow, regulate, or ban payday loans. As of 2020, 12 states and the District of Columbia have banned payday loans entirely. Several other states have capped the interest rate on payday loans at 36% or less, which makes payday lending unprofitable, so most lenders don't operate in those states.

However, payday lenders often incorporate in states with lax regulations or operate offshore so they can skirt state authority. So even if payday loans are illegal in your state, you might still be able to get one from an online lender. That said, they are riskier than regular loans and are generally to be avoided.

Payday loan alternatives to consider

Due to the high costs and the risk involved, you should exhaust all possible alternatives before considering a payday loan. Here are some options to consider:

Best Emergency Loans

There are options for getting emergency loans if you need cash fast. Start by asking your lender if they offer emergency loans or look into personal loans from banks, credit unions, peer-to-peer (P2P) lending marketplaces, or even your credit card issuer. These options are not only likely to have lower interest rates than payday loans but also provide longer repayment terms.

  • Personal loans from online lenders, banks, or credit unions: Unsecured personal loans are repaid in monthly installments, usually over two to five years. Rates for borrowers with fair credit can top 30%, which is still lower than most payday loans.
  • Payday alternative loans (PALs): Offered by some federal credit unions, PALs allow you to borrow between $200 and $1,000 for one to six months and typically carry APRs of 28% or less. You must be a credit union member for at least a month to qualify.
  • Credit card cash advance: Cash advances are often costly — you'll typically pay an upfront fee and a higher interest rate. But they are a source of fast cash and might cost less than a payday loan.

Payday Loan Alternatives

  • Borrowing from friends and family: If you have supportive friends or family members, they might be willing to help you out of a financial bind.
  • Bill payment assistance: Some organizations offer help with paying utility bills. Check programs in your state for options.
  • Emergency assistance programs: Many community organizations and faith-based groups provide emergency assistance, either directly or through social services programs. A few examples: Salvation Army, Catholic Charities, and United Way.
  • Income advance apps: These apps can help you get an advance on your paycheck in exchange for a small fee. They're a cheaper option than a payday loan and an alternative if you need cash in between paychecks.

Payday Loan Consolidation: What It Is and How It Works

Payday loan consolidation involves taking out a new loan with a lower interest rate and using it to pay off multiple payday loans. You'll still have debt, but you'll be paying less in interest and fees. You can consolidate payday loans using a personal loan from a bank, credit union, or online lender.

While debt consolidation has its benefits, it's also important to keep in mind that you're still borrowing money. You will need to have the ability to make the monthly payments on the new loan, or you could end up worsening your debt problem.

Protections for servicemembers

Active-duty servicemembers and their dependents have protections under the Military Lending Act (MLA). The MLA caps the annual percentage rate (APR) on most consumer loans to active-duty servicemembers and their covered dependents at 36%.

The 36% APR cap includes finance charges as well as credit insurance premiums, application fees, add-on products, and other fees that are included as part of the loan. The MLA also prohibits lenders from requiring active-duty servicemembers and their covered dependents to:

  • Waive their rights to legal recourse
  • Submit to mandatory arbitration
  • Agree to mandatory allotments from paychecks
  • Provide unreasonable notice of legal action

The protections apply regardless of the length of the servicemember's service.

The Bottom Line

Payday loans may seem like a quick and easy solution when you're short on cash, but they're an extremely expensive form of borrowing. They often lead to more financial troubles, not less.

Before opting for a payday loan, explore all your other options, such as asking for an advance from your employer, borrowing money from friends and family, getting a loan from a bank or credit union, or working out an extended payment plan with your creditors. Payday loans should only be considered as an absolute last resort.

If you find yourself in the situation where you can't repay a payday loan, consider contacting a credit counseling agency or a lawyer specializing in debt. They can help you develop a payment plan and negotiate with the lender to try to stop the cycle of debt.

Frequently asked questions

Is a payday loan secured or unsecured?

Payday loans are typically unsecured. This means you don't have to give the lender any collateral or borrow against a valuable item as you might in a pawn shop. Instead, the lender will normally ask you for permission to electronically take money out of your bank, credit union, or prepaid card account. Alternatively, the lender may ask you to write a check for the repayment amount, which the lender will cash when the loan is due. Under federal law, lenders cannot condition a payday loan on obtaining an authorization from the consumer for "preauthorized" (recurring) electronic fund transfers.

Do payday loans have fixed or variable interest rates?

Payday loans usually have fixed interest rates. This means the interest rate does not change over the life of the loan.

However, many payday lenders charge fees in a way that effectively equates to a variable interest rate. These lenders will charge a fixed fee for borrowing the money, but that fee often equates to a very high APR. So if you were to calculate the APR including all fees, it would appear as though the rate varies depending on how much you borrow and how long you borrow it for.

For example, let's say a payday lender charges $15 per $100 borrowed. If you borrow $100 for 2 weeks, you would owe $115 at the end of those 2 weeks. If you calculate the APR for this scenario, it comes out to around 390%. Now, if you borrow $200 for 2 weeks, you would owe $230 at the end of those 2 weeks. The APR in this scenario comes out to around 521%. So while the fee itself remains fixed, the effective interest rate varies based on the amount borrowed and term length.

Is a payday loan installment or revolving?

Payday loans are typically meant to be paid off in a single lump sum at the end of a short term (usually two weeks). In this sense, they are installment loans, where you borrow a set amount and then repay it, with interest and fees, by a specific date. However, many payday lenders offer an option to "renew" or "rollover" your loan, allowing you to just pay the interest due and extend the loan for another pay period.

From this perspective, payday loans can also be seen as a form of revolving credit, where your payment only covers the accrued interest, and the principal remains outstanding. However, this is not quite like revolving credit on a credit card, which allows you to carry a balance indefinitely. Most payday loans do have to be repaid eventually.

So while payday loans share some characteristics with both installment and revolving credit, they are generally categorized as a form of installment credit, due to their short terms and lump sum repayment structure.

Regardless of how they are categorized, it's important to understand that payday loans are a very expensive form of credit. They often lead borrowers into a cycle of debt that can be difficult to escape. For this reason, payday loans should only be used as a last resort, and after consideration of all other less costly options.

I hope this detailed explanation gives you a thorough understanding of what payday loans are, how they work, their potential pitfalls, and some alternatives to consider. Payday loans are a complex and often misunderstood financial product, and navigating them requires careful consideration and an understanding of the risks involved.

If you are experiencing financial difficulties and considering a payday loan, I would strongly recommend exploring other options first, such as negotiating with creditors, seeking assistance from a nonprofit credit counseling organization, or looking into less expensive forms of credit. Taking on a payday loan is often a decision made in desperation, but it can have long-lasting consequences for your financial health.

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