What is a Payday Loan? Everything You Need to Know

What are payday loans?

Payday loans are advertised as fast and helpful ways to get money to cover unexpected expenses. However, payday lenders can often use predatory practices to get borrowers to accept loan terms that severely damage their long-term financial health.

A payday loan is a high-cost, short-term, unsecured loan that has a principal that is a portion of your next paycheck. Payday loans are often for small amounts of money, commonly $500 or less. Payday loans provide immediate funds, come with extremely high interest rates, usually higher than the average APR for personal loans. 

How do payday loans work?

Payday loan requirements and eligibility

According to the Consumer Financial Protection Bureau (CFPB), payday lenders typically require that you have the following:

• A bank, credit union, or prepaid card account
• Proof of income
• Be at least 18 years of age
• A valid ID

Loan terms and conditions

Payday loans are usually short-term loans that are paid back within two to four weeks. You can get payday loans online or at a brick-and-mortar payday lender. Lenders usually don't conduct a full credit check or take your ability to pay the loan back into account.

Different states have different laws when it comes to payday loans; some states ban payday loans entirely, while others cap the interest rates that lenders can charge.

• States that ban payday loans: Arizona, Arkansas, Colorado, Connecticut, Georgia, Hawaii, Illinois, Maryland, Massachusetts, Minnesota, Montana, Nebraska, New Hampshire, New Jersey, New Mexico, New York, North Carolina, Pennsylvania, South Dakota, Vermont, West Virginia, and Washington D.C. prohibit payday loans entirely by enforcing low interest rate caps.
• States with lenient regulations: Alabama, Alaska, California, Delaware, Florida, Idaho, Indiana, Iowa, Kansas, Kentucky, Louisiana, Mississippi, Missouri, Nevada, North Dakota, Rhode Island, South Carolina, Tennessee, Texas, Utah, Wisconsin, and Wyoming have more lenient regulations. These states allow high-cost payday lending, often resulting in annual percentage rates (APRs) that can exceed 600%. This leniency results in payday loans being readily accessible but at a very high cost for consumers.
• Hybrid regulations: Maine, Michigan, Ohio, Oklahoma, Oregon, Washington, and Virginia have enacted reform laws to reduce payday lending costs while still allowing short-term loans.

Common payday loan terminology

These terms are commonly used and may help you better understand how payday loans work:

• Annual Percentage Rate (APR): The yearly interest rate charged on a payday loan, often extremely high, sometimes exceeding 600%.
• Roll Over: Extending the payday loan by paying only the interest and fees, creating a new loan.
• Principal: The original amount borrowed in a payday loan.
• Default: Failure to repay the loan on time, leading to additional fees or collection actions.
• Fees: Additional charges added to the loan, including processing, late, or rollover fees.

How to apply for a payday loan

1. Compare lenders. Look at different payday loans online to see their offerings. Dig into the fine print of each offering to make sure you understand the loan repayment terms, payday loan rates, and any fees.
2. Fill out an online or in-person application. Once you've decided on a lender, submit your relevant details, often including your bank account information and income.
3. Wait for the lender to process your application. With payday lenders, this process is usually swift, and you'll often get your money on the same day.
4. Receive your money and make a repayment plan. To ensure you don't fall behind on your payments, outline a detailed plan to pay your loan back before you sign on the dotted line.

Real-life example of paying off a payday loan

Let's say you take out a $500 payday advance. Assuming the payday loan rate 400%, that means you'll owe a total of $576 in just two weeks. Here's a breakdown of how you can calculate how much a payday loan will cost you:

Total amount you'll owe = Principal (1+APR x time in years/100)

The above example does not include any additional fees that you may be charged when taking out a payday loan. Make sure you fully understand the potential risks and fees associated with these short-term, high-interest loans.

Dangers of payday loans: high interest rates and debt cycles

High-interest rates and fees

You might be put in a position where you feel like you have to take out a high-interest loan to cover an expensive medical bill or rent check, but you should try to avoid payday loans if at all possible.

With exorbitantly high interest payday rates, these loans can end up costing more than you initially borrowed and can trap you in a cycle of debt. Additionally, payday lenders often target low-income, minority communities and convince them to accept confusing loan terms.

"Payday loans are easy to access compared to traditional bank loans because they don't require collateral," said Durriya D. Pierce, CFP® at Fruitful. "Unlike a mortgage, which is secured by a home, or a credit card, which typically requires a credit check, payday loans don't have anything like that. The application is quick, approval is almost instant, and cash is available right away. While it may seem convenient, that convenience comes at the cost of a high interest rate — sometimes above 100%."

Potential for debt cycles

Generally speaking, consistent, reliable payments on payday loans don't help you build your credit. However, if you default on your loan and your debt is sent to a debt collector, your debts in collection could damage your credit.

If you want to build your credit, a personal loan or a credit card is a better alternative. Lenders will report payments on those financial products to the major credit bureaus, and you'll see a steady improvement in your score over time if you keep up with your payments.

Creating a payday loan repayment plan

If you're struggling to pay off multiple loans, start by assessing your cash flow and choosing a repayment strategy that fits your income. Debt repayment strategies like the snowball or avalanche methods could help you regain control and pay off debt faster.

"Sometimes it feels counterintuitive because people want to pay everything off as fast as possible, but the key is to comb through your cash flow first," said Pierce. "A lot of times, we use the avalanche method, making minimum payments on everything while throwing any extra cash at the highest-interest balance. That way, we minimize the amount of interest paid over time."

Alternatives to payday loans: safer borrowing options

Payday loans vs. personal loans

Personal loans usually have longer loan repayment terms and lower rates than payday loans. However, they sometimes have higher loan minimums, which may mean you'd have to borrow more money than you'd want.

You can find more personal loan alternatives to payday loans with our lists of the best small personal loans and the best personal loans for bad credit.

Typically, bad credit scores are associated with a FICO score below 580. Fixing your credit might make you eligible for better loans with more favorable terms.

Payday loans vs. cash advances

The major difference between a cash advance and a payday loan is that payday loans tend to have higher interest rates and fees than cash advances. Cash advances are often available through your credit card issuer or various apps.

Consider any alternatives you have to payday loans before deciding to get one, as they come with a lot of risk.

Payday loans vs. credit cards

Credit cards are similar to payday loans in that they both offer quick access to cash at high interest rates. However, credit cards provide you with a revolving line of credit, which means you can carry a balance on the card. Alternatively, payday loans provide you with a lump sum that's due by your next paycheck.

Credit cards offer more flexibility, and payday loans are generally more expensive and risky, making credit cards a better long-term borrowing option.

Non-loan financial solutions

Local nonprofits, churches, family members, and even some credit cards are better options for emergency cash than payday loans, said Graciela Aponte-Diaz, former director of federal campaigns at the Center for Responsible Lending and current senior engagement and policy fellow at the Consumer Financial Protection Bureau.

"What we've seen in states that don't have payday loans is that there are various resources to help people during emergencies or hardship, but they are out-marketed in states that have predatory lending," Aponte-Diaz said.

Before you're in a situation where you're staring down a payday loan, you might consider building an emergency fund to cover three to six months' worth of living expenses if possible.

"The average financial planner will tell you to save three to six months' worth of expenses for a fully funded emergency fund," said Pierce. "I take it a step further and set smaller milestones. First, I recommend saving $1,000. If that means putting aside $100 a month for 10 months, then that's the goal. Beyond that, let's aim for one month's worth of expenses, then two, and so on. This makes the process more digestible so you can contribute to your goals over time."

Payday Loan Scams and What to Do if You're Targeted

Payday loan scams are common, with scammers often posing as legitimate lenders and asking for upfront fees or personal information. These scams may include fake loan offers or threats of legal action for non-payment, even if you never took out a loan. It's crucial to be cautious of unsolicited offers, and always verify the legitimacy of the lender before providing any personal or financial details.

If you're targeted by a payday loan scam, report it to the Federal Trade Commission (FTC) or your state's attorney general. Avoid paying any upfront fees, and don't share sensitive information like your Social Security number or bank account details. You can also contact your bank if you suspect fraudulent activity to prevent further financial damage.

Payday loans pros and cons

Payday loan pros

• Fast funding. If you need cash fast and have exhausted all other options, then a payday loan could provide the flow of cash you are in desperate need of.

Payday loan cons

• The amount you could end up paying is extremely high. Per the Consumer Finance Protection Bureau, a typical two-week payday loan with a $15 per $100 fee equates to an APR of almost 400%. To put that number in context, the APRs on most personal loans cap out at 36%, and credit card rates can get over 30%.
• You could hurt your credit. While payments made on payday loans aren't usually reported to the three major credit bureaus (Experian, Equifax, and Transunion), if you default on your loan and your debt is sent to a debt collector, your debts in collection could negatively impact your credit.
• You could trap yourself in a cycle of debt. If you fall behind on payments, the interest you're being charged can continue to add up until you struggle to pay it back. Your options to put your loan in forbearance (pause your payments) are also limited with payday loans.

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