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Payday Loans: How They Work, The Risks, and Are They Legal?

kennethb
Kenneth Boyd Updated: September 11, 2023 • 5 min read
Payday check

Key Points:

  • Payday loans are short term loans with high interest rates.

  • Lenders base the loan amount on a percentage of your income, and borrowers usually provide a pay stub with the loan application.

  • Most loans do not require a credit check, and borrowers may be charged high fees for missed payments.

Finding a source of funds when you’re under financial stress can cause anxiety, and some consumers make decisions without considering all of their options. If you need funds quickly, a payday loan is one possible solution.

In this article, we define payday loans, explain how you can apply for a loan, cover loan risks, and review alternative loan options. Is a payday loan secured or unsecured? Read on to find out more.

What is a Payday Loan?

What are payday loans? A payday loan is a type of short-term, high-interest rate loan. A lender extends your credit based on your income, and a percentage of your paycheck is used to repay the loan.

Most payday loans are unsecured, meaning that the borrower does not provide collateral to secure the loan. A payday loan (or cash advance loan) is one of several ways to borrow money quickly to meet a short-term cash need.

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How Do Payday Loans Work?

When you apply for a payday loan, you typically provide a pay stub to show proof of income. The lender uses your income to determine how much you can borrow.

Most payday loan agreements require repayment in 30 days or less. Payday loans have a fixed interest rate, so that the lender knows exactly how much principal and interest (and any fees) will be repaid when the loan term ends. If a borrower has the option of extending the term of the loan, they will incur more interest and possibly additional fees.

How Do I Get a Payday Loan?

Here are the steps to obtain a payday loan:

  1. Some lenders have physical office locations and others do business online. Borrowers complete a credit application in person or online.
  2. The loan principal (amount borrowed) is based on a percentage of your income, and most payday lenders do not perform a complete review of your credit.
  3. If your loan is approved, you may write a personal check that the lender will hold for loan repayment on the loan’s maturity date. The lender may also ask for electronic access so the loan is repaid automatically through your bank account.
  4. The amount you pay is the principal borrowed, plus interest and fees.
  5. Loan amount limits may be determined by state law, and loans range from $100 to $1,000. On average, a payday loan must be repaid in two weeks.

What Are Payday Loan Interest Rates?

Loan interest rates are calculated using the annual percentage rate (APR). APR is calculated as the total interest, fees, and other costs a borrower will pay in a year, compared to the principal amount owed. Note that APR is not computed using compounding interest, which is interest that accumulates on a loan over time.

The Consumer Federation of America, a non-profit consumer organization, reports that: “Loans typically cost 400% annual interest (APR) or more. The finance charge ranges from $15 to $30 to borrow $100. For two-week loans, these finance charges result in interest rates from 390 to 780% APR.”

Risks of Payday Loans

The Truth in Lending Act requires lenders to fully disclose the cost of payday loans. However, some borrowers do not carefully read the loan documents before borrowing funds. Keep in mind that one in five borrowers default on payday loans. Here are the risks of payday loans:

  • Extremely High-Interest Rates: As discussed above, the cost of a payday loan is 400% APR or more. Compare a payday loan interest rate to the interest rate on a car loan. Car and Driver reports that a borrower with poor credit will pay 16% to 20% APR for a used car loan. As you can see, payday loans are very expensive for borrowers.
  • Installment Loans: Some lenders offer installment loans with more time to repay the loan. An installment loan will increase the total interest and costs paid by the borrower.
  • Repeat Borrowing: The Consumer Financial Protection Bureau (CFPB) states that up to 80% of payday loan borrowers take out multiple payday loans over time. The more money you borrow, the more you’ll pay in interest and fees.
  • Borrowing to Repay Another Loan: Borrowing more money from another source to repay the payday loan creates even higher interest costs.

Are Payday Loans Legal?

Payday loans are permitted in some states. Laws are in place to regulate payday loan fees, interest rates, and lending practices. If a lender makes two attempts to charge a borrower’s account that are not successful, the lender needs permission from the borrower before trying again.

Keep in mind that these states do not permit payday loans: Arizona, Arkansas, Connecticut, Georgia, Illinois, Maryland, Massachusetts, Montana, Nebraska, New Hampshire, New Jersey, New Mexico, New York, North Carolina, Pennsylvania, South Dakota, Vermont, and West Virginia.

Payday Loan Alternatives to Consider

If you’re in a financial bind and need funds quickly, you can find an alternative to payday loans. Consider any assets that you might use as collateral for a secured loan. In addition to a home or car, some individuals own other property, equipment, art, or other collectibles that might serve as collateral for a loan.

  • Bad-Credit Online Loans: Consumers with poor credit can apply for loans through an online lender. They will review your application quickly, and provide funds if you’re approved. Borrowers may be charged an APR of between 10% and 30%, which is much lower than a payday loan, but you may have to pay a large loan origination fee. The term of the loan can be two to four years or longer.
  • Home Equity Line of Credit: Your home’s equity is the difference between your home’s appraised value and the remaining balance of your loan. A home equity line of credit allows you to borrow against your home equity as you need funds. The equity serves as collateral for the loan.
  • 401(k) Loans: A 401(k) plan is a retirement plan that many investors have through work. The worker can choose to invest a portion of their salary into the account, and the company may match a portion of the dollars invested. Your plan may allow you to withdraw funds from the plan, and you should consult with a tax advisor regarding the tax impact on these loans.

The Bottom Line

Financial stress is upsetting, but don’t make a borrowing decision without doing your homework. It’s crucial that you stay informed so that you can make the best financial decisions for your situation. Consider all loan options, including personal loans, home equity loans, and 401(k) loans.

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FAQ

Why are payday loans bad?

Payday loans are expensive, compared to other types of loans, and may impact your credit rating. If you default on a payday loan, the lender will likely report the default to credit bureaus, and your credit score will decline. Borrowing money in the future will be more difficult.

Is a payday loan secured or unsecured?

Collateral refers to something of value that is pledged to secure a loan, and most payday loans are considered unsecured loans. Car loans are secured by vehicles, and a mortgage loan is secured by property. Most payday loans, however, are not secured by a specific asset.

Are payday loans fixed or variable?

Payday loans are structured so that the entire loan is repaid using funds from a paycheck. Payday loan interest is fixed, which allows the lender to calculate the exact amount of interest due when the loan agreement is set up.

Why are payday loans so high?

Interest rates are high to compensate the lender for the risk of loan defaults. As mentioned above, one in five borrowers default on payday loans. The high rate of interest helps the lender make up the losses if a borrower defaults.

What are the highest payday loan amounts?

Consumers may pay as much as 750% to 800% APR for a two-week loan, and the average payday loan carries a 400% APR.

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kennethb
Written by Kenneth Boyd

Kenneth Boyd is a four-time Dummies book author, including the book Cost Accounting for Dummies. Ken writes, blogs, and provides video content on business topics.