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Payday Loans: How They Work, What They Cost

September 2, 2016
Banking Basics, Credit Score, Loans, Payday Loans
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A payday loan offers fast cash for people who have an income, but bad credit. Payday loans are typically small, less than $500.

But payday loans are the most expensive way to borrow money. If the loan isn’t repaid in full on the first payday, a new finance charge is added and the cycle repeats. Within a few months, borrowers can end up owing more in interest than the original loan amount.

Because short-term lending is subject to a patchwork of state and federal laws, these loans look different in nearly every state. They may go by names such as cash advance, deferred deposit, deferred presentment, or credit access business.

How do payday loans work?

How much can I borrow through a payday loan?

What do I need to get a payday loan?

How much does a payday loan cost?

How does a payday loan affect my credit?

What are my alternatives for fast cash?

Payday loan alternatives to avoid



Payday lending is highly controversial and is effectively banned in 18 states. It has come under increasing scrutiny from federal regulators, who decry the practice as deceptive and harmful to consumers.

Payday lenders say their business gives millions of hardworking Americans access to desperately needed cash in an emergency. Consumer advocates point out that payday lenders only really profit when borrowers can’t repay their loan on time, a fact that motivates lenders to overextend credit, sinking borrowers into an escalating and dangerous spiral of debt.

For this reason, financial experts caution people to steer clear of payday loans, particularly if there’s any chance they can’t repay the loan immediately, and to seek out one of the many alternative lending sources available instead.

How do payday loans work?

A payday lender will confirm your income and checking account information and deliver cash in as little as 15 minutes at a store or by the next morning with an electronic transfer if the transaction is done online.

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

If the loan is issued at a store, the lender will make an appointment for you to return when the loan is due and call a day or two in advance. If you don’t show up, the lender will run the check or withdrawal for the loan amount plus interest. Online lenders will initiate an electronic withdrawal.

Online payday loans can go through a direct payday lender, which makes its own decisions about loans, and brokers, who simply sell your information to the highest bidder. If you feel you have to take a payday loan, go through a direct lender.

How much can I borrow through a payday loan?

Thirty-two states allow payday lending. All but four — Maine, Utah, Wisconsin and Wyoming — cap the maximum loan amount.

The highest cap is $1,000, in Delaware, Idaho and Illinois; the lowest cap is $300, in California and Montana. The most common cap is $500. A few states also limit each payday loan to no more than 25% of a borrower’s gross monthly income, if that’s less. Nevada and New Mexico cap each loans at 25% of the borrower’s gross monthly income rather than a fixed dollar amount. Details on state limits can be found here.

This doesn’t mean you’ll be approved for the highest amount allowed by law. A payday lender will consider your income, expenses and payday lending history to determine how much you can reasonably be expected to pay back.

The industry has calculated that the average payday loan is $350 to be repaid in two weeks.

What do I need to get a payday loan?

To qualify for a payday loan, you typically need an active bank account, an ID and proof of income such as a pay stub. You must be at least 18.

You don’t need good credit to take out a payday loan.

Lenders check a specialized consumer reporting agency to ensure that you don’t have outstanding payday loans, a wage garnishment or other judgment against you, or a history of bad checks or bankruptcy.

You can be rejected for a payday loan, despite having income and a bank account, for several reasons. They can include:

  • You don’t make enough money. Some lenders require as little as $500 monthly net income; some require more.
  • You don’t meet their repayment requirements. States may have specific laws limiting how much of your income you can spend, and each lender may have its own proprietary algorithm to gauge the risk you won’t repay.
  • You already have an outstanding loan. Lenders subscribe to a company that can track loans in real time.
  • You are active-duty military. Federal law prevents payday lenders from making short-term loans at more than 36% APR to military members. Some lenders find ways around the law’s limits, but others exclude them as customers.
  • You have a recent bankruptcy.
  • You have recent bounced checks.
  • You have not been employed long enough.
  • Your bank account has been opened too recently.

How much does a payday loan cost?

The cost to take out a loan varies by state and by lender. States that allow payday loans typically cap the maximum allowable interest at between $10 and $30 per $100 borrowed.

The cost of a loan from a storefront payday lender is typically $15 for every $100 borrowed, according to research from the federal Consumer Financial Protection Bureau.

At that rate, a $350 loan — the amount of the median storefront loan — costs $52.50. When it’s time to repay, usually in two weeks, the total amount owed is $402.50.

Online payday lenders tend to charge higher rates and often claim exemption from state rate caps. The CFPB found the median online payday loan cost $23.53 per $100 borrowed.

However, most loans are extended. Nineteen of the states that authorize payday lending allow lenders to roll over a loan, in which case the borrower pays only the interest fee and extends the loan for two weeks. He then gets a new, second interest fee tacked on. The remaining states don’t prohibit a borrower from taking out back-to-back loans, which has the same effect.

Most consumer loans are clearly labeled by annual percentage rate, which includes the total cost of fees and interest over a year. That $15 per $100 fee for a two-week loan effectively is a 391% APR.

How does a payday loan affect my credit?

Most payday lenders don’t check a borrower’s credit history or credit score with the big three credit bureaus — TransUnion, Equifax and Experian — to decide who gets a loan. Nor do they report on-time payments to the bureaus so that your credit scores improve.

That said, if you fail to pay the loan, the credit bureaus will likely hear about it and your credit score will be damaged. While the payday lender might not report a defaulted loan to the credit bureaus, the collections agency to whom the lender sells the defaulted loan could.

If the collections agency calculates there’s only a very small chance of the loan getting repaid, it may cut its losses and report the default to the credit bureaus immediately. If the agency has a shot at getting paid, it would likely hold off on reporting a missed payment to use it as leverage.

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

Both storefront and online payday lenders will do their best to collect the money themselves first, because when they sell debts to collections agencies they get only a few pennies for each dollar of debt.

The effort will happen on two fronts: Lenders will continue to try to withdraw money from your account, sometimes breaking amounts into smaller chunks to increase the chance the payment will go through. Each failed attempt can trigger bank fees against you.

At the same time, payday lenders will start calling you, sending letters from their lawyers, and even calling your personal references.

A second alternative might be that a lender may try to negotiate a settlement with you for some part of the money owed.

The third step is to outsource the loan to a debt collector, a step that can happen in as little as 30 days. A debt collector, also known as a collections agency, will report to the credit bureaus and could file a civil suit, if the amount is large enough to warrant the expenditure. A court judgment against you remains public for seven years and can lead to seizure of your assets or a garnishment of wages.

What are my alternatives for fast cash?

Your friends and family may offer the most flexibility and the best lending terms, but not everyone has this option or feels comfortable using it.

If you have a little bit of time, you can investigate ways to dig up fast cash or more savings in your budget — everything from selling possessions to increasing your income with side gigs.

And once your immediate cash emergency passes, start building an emergency fund. If you can save even a few hundred dollars over time, then you are repaying yourself rather than the lender when emergencies arise. Long term, it’s your best hope to get off the paycheck-to-paycheck treadmill.

Payday loan alternatives to avoid

Payday installment loans: Available at both storefronts and online, these loans extend repayment terms to as long as three years. You don’t need good credit — they often advertise themselves as no-credit-check installment loans — but you typically must meet the requirements of a payday loan: a paycheck and a bank account. Interest charges mount quickly over time: A $2,000, three-year loan at 400% APR will end up costing over $16,000.

Auto title loans: These short-term loans, where they’re legal, require you to hand over the title to your vehicle as collateral for the debt. They’re often compared to payday loans, and the interest rates are comparable, but they can be even worse: If you don’t repay, the lender can seize your car.

This post was updated Sept. 2, 2016. It was originally published May 26, 2016.