What Is a Payday Loan and How Does It Work?

Payday loans are high-cost, short-term and risky loans. Consider alternatives before getting a payday loan.
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Written by Jackie Veling
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Nerdy takeaways
  • Payday loans are small, expensive loans you repay all at once, typically on your next payday.

  • Because they often lead to a cycle of debt, payday loans should be reserved for emergencies.

  • There are usually no credit benefits to payday loans, but defaulting can impact your credit score.

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What is a payday loan?

A payday loan is a high-cost, short-term loan for a small amount — typically $500 or less — that’s meant to be repaid with the borrower's next paycheck. Payday loans require only proof of identification, income and a bank account and are often made to people who have bad or nonexistent credit.

Financial experts caution against payday loans — particularly if there’s any chance the borrower can't repay the loan — and recommend alternative lending sources instead.

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How do payday loans work?

A payday lender will confirm your income and checking account information and deliver cash then and there at a store. For online transactions, the lender will send funds electronically to your bank account the same or next day.

In exchange, the lender will ask for a signed, post-dated personal check or permission to electronically withdraw money from your bank account on the due date. The loan is due on your next payday, typically in two weeks, but sometimes in one month.

If the loan is issued at a store, you may return before or on the payment due date. If you don’t show up, the lender will repay itself by running the check or withdrawing repayment from your bank account. Online lenders use an electronic withdrawal.

Frequently asked questions

Payday loans are unsecured, meaning you don’t have to pledge your car or other property to qualify.

Payday lenders typically charge a fixed fee that’s due with the loan repayment.

Payday loans are neither installment nor revolving credit. These loans are repaid all at once shortly after they’re borrowed. An installment loan is repaid over time in smaller amounts, and revolving credit accounts such as credit cards allow you to borrow and repay money as you need it.

How much do payday loans cost?

Payday loans typically cost $10 to $30 for every $100 borrowed, according to the Consumer Financial Protection Bureau

Consumer Financial Protection Bureau. What is a payday loan?. Accessed Jul 11, 2024.

If you don’t repay the loan in full on the due date, the lender may add a fee to extend the due date

. If this cycle repeats, borrowers can end up owing more in interest than the original loan amount.

That’s why payday loans are risky — it's easy to get trapped in a cycle of debt and expensive to get out.

Payday loans and interest rates: An example

Payday and other high-cost lenders prefer to explain the cost of borrowing in terms of fees rather than interest. For example, if you borrow $100, and the fee is $15 for every $100 borrowed, your total repayment will be $115.

However, payday lenders, like all lenders, must disclose the annual percentage rate the fee equates to before the borrower signs a loan agreement. A $100 payday loan with a $15 fee due in two weeks equates to an APR of 391%.

The APR is the best apples-to-apples cost comparison tool for loans and credit cards. For example, if a credit card has a 15% APR, a personal loan has a 25% APR and a payday loan has a 350% APR, then the credit card is the least expensive option and the payday loan is the most expensive.

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

Depending on the lender and the state you live in, the payday lender could charge a late fee or returned payment fee.

Your bank or credit union may charge a nonsufficient funds fee or an overdraft fee if repaying a payday loan causes you to overdraw your account.

Did you know...

Payday lenders in sixteen states are required or allowed to provide extended payment plans to borrowers who request them, default or are at risk of defaulting, according to a 2022 report from the Consumer Financial Protection Bureau. Extension rules vary by state. These states include: Alabama, Alaska, California, Delaware, Florida, Idaho, Indiana, Louisiana, Michigan, Mississippi, Nevada, South Carolina, Utah, Washington, Wisconsin and Wyoming.

How do payday loans affect credit?

Paying back a payday loan doesn't usually build credit. Most payday lenders don’t report on-time payments to credit bureaus, so the loan can't help your credit score.

If you don’t pay the loan back, however, your credit can be damaged. The payday lender may report the default to the credit bureaus or sell the debt to a collections agency that will do so, which will hurt your score.

Are payday loans legal?

Each state makes its own payday loan regulations, usually by setting limits on the APR lenders can charge on a small loan, based on the loan’s size and repayment term

National Consumer Law Center. State Rate Caps for $500 and $2,000 Loans. Accessed Jul 17, 2024.
. Many states have enacted tight restrictions on the cost of consumer loans in the past few years, effectively outlawing payday loans, but they’re not illegal everywhere.

According to a 2022 analysis by the Pew Charitable Trusts, payday loans are either banned or so heavily regulated loan providers don’t operate in the District of Columbia and these 18 states: 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 loans and the Military Lending Act

The Military Lending Act (MLA) prevents lenders from providing loans with APRs above 36% to active-duty military members, their spouses or certain dependents

Federal Reserve. Military Lending Act. Accessed Jul 17, 2024.

Here’s who the law covers:

  • Active-duty service members.

  • Reserve component members serving on active duty for 30 days or longer.

  • Spouses, children and other covered dependents.

Because of the MLA, payday and other high-cost lenders frequently don’t allow members of the military to apply for a loan.

Did you know...

Several studies have shown that payday lenders disproportionately target low-income communities and communities of color by locating their businesses and advertisements in those areas. According to a 2012 study of payday loan borrowers by the Pew Charitable Trusts, the following groups are more likely than others to use payday loans: Black Americans, those without a four-year college degree, home renters, those who are divorced or separated and those earning less than $40,000 a year.

How to get a payday loan

  1. Compare alternatives: Because payday loans can cause financial damage, be sure that getting one is better than any alternative, even if that means being late on your other financial obligations. Ask your landlord for an extension, get on a payment plan for utility bills and reach out to creditors to ask for a payment deferral. In some cases, it may be worth a potential hit to your credit or late fee to avoid a potentially predatory loan.

  2. Check payday lender reviews: Before you get a payday loan, see what other borrowers have said about the lender. If you’re considering an online payday lender, search the CFPB’s complaint database, the Better Business Bureau and forums like Reddit where users may share their experiences. If you’re borrowing from a lender near you, Google reviews can provide some insights.

  3. Have the necessary documents: To qualify for a payday loan you typically need an active bank account, a government-issued ID and proof of income such as a pay stub. You must be at least 18 years old. Some lenders also require a Social Security number. Bring these documents to a storefront lender or have them ready if you plan to apply online.

  4. Look for the disclosures: Though payday loan rules vary by state, you should have access to some information before you borrow no matter where you live. This includes the lender’s license to do business in most states, the amount you’re expected to repay and when, the payday loan fee amount and what APR it equates to. If a lender isn’t willing to provide any of this information, consider it a red flag.

  5. Have a plan to repay the loan: The key to avoiding a payday loan debt trap is to determine how you’ll repay the loan in full on or before the due date and make your other regular expenses. Knowing this when you take the loan will keep the lender from charging additional fees, and it’ll prevent you from having to borrow again.

Payday loan alternatives to consider

Use an interest-free cash advance app. Mobile apps like Earnin, Dave and Brigit can offer low-fee advances on your paycheck, though there are eligibility requirements and caps on how much you can borrow.

Get a personal loan from a credit union or online lender. A personal loan will likely carry a lower APR than a payday loan, so it’s more affordable. Credit unions tend to offer the lowest rates for bad-credit applicants, and many offer payday alternative loans, specifically, but you’ll need to become a member before applying. Online lenders also serve bad-credit borrowers and can fund loans the next business day, but rates may be higher

Ask if your bank offers a small-dollar loan. Traditional banks are beginning to offer small-dollar loans that can cover emergency expenses. U.S. Bank’s Simple Loan, Bank of America’s Balance Assist Loan and Wells Fargo’s Flex Loan all provide short-term funds for existing customers in good standing.

Borrow money from a family member or friend. A loved one may be able to spot you the funds. This will save you money on interest, and you won’t have to undergo a credit check. Just make sure you agree to the terms of the loan, such as when you’ll pay it back.

Reach out to a community organization. There are local and regional organizations that provide free funds to cover essential expenses. Check NerdWallet’s database of financial assistance programs to see what’s available in your state.

Use a BNPL app to cover a necessary purchase. Buy now, pay later” apps like Affirm, Afterpay and Klarna can split up your online or in-store purchase into equal installments, often for zero interest and no fees if you pay on time. These apps may be a smart solution for covering an essential expense, like a mattress or toiletries.

You could also consider a credit card cash advance or a pawnshop loan. Though these options should offer lower interest rates than a payday loan, they are still costly.

Once your immediate cash emergency passes, start building an emergency fund. If you can save even a few hundred dollars over time, then you’re repaying yourself rather than a lender when emergencies arise.

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