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Published 20 February 2024
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What is a Payday Loan? How Payday Loans Work

Payday loans are short term loans that are typically taken out to cover unexpected, emergency expenses. However, they are an expensive form of borrowing so you should always consider the alternatives.

Payday loans, sometimes referred to as same day loans, are a type of short term unsecured loan.

These loans usually come with very high interest rates. Even though they are regulated and there is a cap on the interest and fees lenders can charge, payday loans are still often much more expensive than other forms of borrowing. This means there are likely to be better options available if you need to borrow money.

At a glance:

  • Payday loans are a short-term and high interest form of borrowing.
  • It can typically be a very expensive way to borrow, costing more than other loans and types of credit.
  • If you’re struggling financially, it may be better to get professional help from a charity or free debt advisor instead of applying for a payday loan.

How do payday loans work?

Payday loans are intended to cover short term cash flow issues until your next payday when you would then repay the loan in full, plus interest, as agreed. 

However, the definition of payday loans has become broader and can now refer to high cost short term loans that are repaid in instalments over several months. That being said, repayment terms for these short term loans are still typically less than 12 months.

Several online lenders offer payday loans and applying for one can be relatively quick. After the lender has checked and approved your application the money can often be paid into your account on the same day.

Lenders will assess your finances to decide whether you can afford to repay the loan, which usually includes a credit check.

Payday loans can be repaid in several ways:

  • You could make one payment to clear your debt at the end of the term or, if the term is longer, you may be able to repay in instalments.
  • A common option is to set up a recurring payment, also known as a continuous payment authority (CPA). This gives lenders the right to take the money they are owed from your account using your bank card details. Unlike a direct debit, this payment instruction is directly with the business rather than your bank.If payment is declined by your bank, lenders can only try to deduct funds twice via CPA.
  • Alternatively, you may be able to set up a direct debit or standing order to repay the loan. Keep in mind that direct debit offers some protection from mistakes and errors through the Direct Debit Guarantee.

Are payday loans regulated by the FCA?

Yes, all payday lenders need to be regulated by the Financial Conduct Authority (FCA) and are required to meet certain standards. Importantly, firms must check whether you would be able to afford the repayments, and rules limit the amount payday lenders can charge in interest and fees.

If a lender isn’t regulated by the FCA, it could be a loan shark. Loan sharks are lenders that operate illegally, often charging higher interest rates and using threats and intimidation to extort money from you.

When searching for a payday loan online, you may come across a price comparison website. Payday loan firms have to list their products on at least one price comparison website, a rule that aims to make sure borrowers can find a good deal. These price comparison websites must also be regulated by the FCA.

You can check whether a firm is regulated by the FCA using the Financial Services Register.

How much do payday loans cost?

The average annual percentage rate (APR) of a payday loan could be up to 1,500%, which is significantly higher than many other forms of borrowing. For example, the APR on a typical credit card could be around 20%. 

As the APR tells you how much it costs to borrow over a year, and payday loan terms are often less than a year, taking out a payday loan may not cost as much as the APR indicates.

Payday lenders need to comply with certain rules set by the FCA, which limit the amount they can charge in interest and fees.

  • Lenders can’t charge more than 0.8% of the amount borrowed in interest and fees per day.
  • In total, borrowers should never pay back more than they borrowed in interest and fees.
  • If borrowers miss any payments, the default charges can’t exceed £15 plus interest on the amount borrowed.

So, as a result of these rules, if someone takes out a loan for a term of 30 days and repays it in full and on time, they should not pay more than £24 in fees or charges per £100 they borrow.

Payday loans for bad credit

Generally, people with higher credit scores have a better chance of being accepted for a payday loan, and those with bad credit may be restricted to products with higher interest rates from specialist lenders.

Ultimately, if you have bad credit, a history of struggling to meet repayments and are finding it difficult to get a loan elsewhere, taking out a payday loan will almost certainly not be the answer. 

If you want a payday loan to buy something that can be delayed or isn’t essential, saving up or asking for help from friends and family are often better options. 

And if you think you need a payday loan to cover rent, bills and other essentials, an expensive payday loan is likely to make things worse. You should never take out payday loans to pay off other loans or to cover a gap between your monthly income and expenditure. 

When you’re struggling to make ends meet, you may not be able to make the payday loan repayments on top of your other expenses. You could then fall into a cycle of debt.

Before taking out a loan to cover any financial problems, you can get free help from a debt charity such as StepChange, National Debtline or Citizens Advice. Advisers will be able to talk to you about your finances and debts and help you to work out the best way forward.

A debt charity could also help you look at whether you’re claiming all the benefits, grants and support schemes you’re eligible for. These might include:

  • Universal Credit if you’re out of work or on a low income
  • Child Benefit if you’re responsible for a child under 16
  • Carer’s Allowance if you look after someone who’s ill or disabled

Some water and energy companies run hardship schemes, which you might be able to apply for if you’re struggling to pay your bills. Your local council may also be able to help with essential costs.

Disadvantages of payday loans 

The main attraction of payday loans is that you can get a small loan if you need cash quickly. But the risks of payday loans far outweigh the advantages and alternative forms of borrowing will almost always be more appropriate.

Some of the risks and disadvantages of payday loans include:

  • They have high interest rates and are a very expensive way to borrow.
  • They come with short repayment terms.
  • They will usually appear on your credit history, so other finance providers will be able to see that you’ve taken out this loan. This could affect your chances of getting a mortgage or other credit as lenders might assume you are in financial difficulty or struggling to manage cash flow.
  • If a payday loan repayment is automatically taken out of your account, you may not have enough money left in your account for bills and other essentials.
  • You could end up in a cycle of debt if you fail to repay the loan and costs mount up.

What if I can’t repay a payday loan?

You can cancel your payday loan agreement within 14 days of taking it out. You will need to give back the amount you borrowed and pay any interest charged. The lender will refund any other fees.

If this period has passed and you’re struggling to repay your loan, contact the lender as soon as possible. They should be fair and try to help you work out what to do next – by agreeing a new payment plan, for example.

You can cancel your payment, but make sure you tell the lender you’ve done this. Bear in mind you will still owe the money and the lender can still charge you interest and fees.

At this point, it may be useful to contact a debt adviser for help. They can work with you to figure out what the best course of action is, and they can also talk to the lender on your behalf. These debt help services are completely free.

Payday lenders may give you the opportunity to ‘roll over’ the outstanding balance on your loan for another month. However, while this gives you more time to pay, you will incur extra fees and charges. Lenders are only allowed to offer this option twice.

If you do agree to extend your loan, the lender needs to provide you with an information sheet warning you about the risks of borrowing more, and telling you where you can access debt help. 

If you think you’ve been treated unfairly by a payday lender, you can submit a complaint to the lender. If this isn’t resolved, you can escalate the matter and complain to the Financial Ombudsman Service.

Payday loan alternative: what are my options?

Payday loans are unlikely to be your best option if you’re short of cash. There are alternatives if you need to borrow money, but whenever you borrow money you should be confident that you can pay it back.

Personal loan

Payday loans are a type of personal loan, but you may be able to find lower rates of interest from standard personal loans. The interest rate on these loans will depend on your credit score and lenders will set their own eligibility requirements.

There are options if your credit score is poor. These bad credit loans will come with higher interest rates, but they shouldn’t be as high as those on payday loans.

Bear in mind that you will normally need to borrow a minimum amount with a personal loan, so they may not be suitable if you only need to borrow a small sum. These loans are also typically repaid over terms longer than 12 months, which is longer than the terms typically available with payday loans.

You can often check your eligibility for a personal loan without affecting your credit score, so you can see your chances of approval before applying.

Credit union loan

Credit unions are community organisations that can offer loans at competitive interest rates. They may be an option if you need to borrow some money, but you will need to check if you’re eligible for a loan from a particular credit union as they will have their own individual criteria.

Credit unions in England, Wales and Scotland can only charge 42.6% APR on their loans (3% per month). In Northern Ireland, they can only charge 1% a month or 12.68% APR.

» MORE: Borrowing from a credit union

Budgeting loan or advance

If you’re receiving certain benefits, you may be eligible for a budgeting loan or advance from the government to help with emergency costs. With both these options, you only repay the amount you borrow and repayments are taken from your benefits.

» MORE: Budgeting loans and budgeting advances explained

Credit card

Used wisely, credit cards can be a cheaper way to borrow money than a payday loan. If you manage to get a 0% interest card, you won’t need to pay any extra charges, as long as you repay it in full before the 0% period ends. But the best offers are typically only available to those with good credit histories.

Even cards without a 0% interest period won’t charge any interest if you clear your credit card in full each month. If you don’t clear your balance each month and are charged interest, the rates should still be cheaper than a payday loan.

However, only spend money on your credit card that you can afford to repay. Interest charges on credit cards can accumulate over time if you don’t pay them off, which could leave you struggling with debt.

Overdraft

If you have an authorised overdraft, or arranged overdraft, with your bank, you may be able to use this to cover any emergency expenses.

Even though interest rates on overdrafts can be expensive (unless you have an interest-free overdraft limit), dipping into your overdraft will often still be cheaper than a payday loan. However, make sure you don’t rely on your overdraft and use it too often as this could end up being very costly.

» MORE: How overdrafts work

Family and friends

If they can afford it and are willing to lend to you, you could ask friends or family members for a loan.

This can be a cheap way of borrowing without needing to go to the lenders, but make sure you and the person lending the money are happy with the arrangement as it could affect your relationship.

To try to avoid any disputes, you should put the terms of the agreement down in writing, including how much you owe, the plan for repayments, and what will happen if you can’t make a payment.

Where can I get help if I’m in debt?

If you’re struggling with debt and are finding it difficult to make repayments, charities that can help with free advice include:

  • StepChange
  • Citizens Advice
  • National Debtline

Charities like this can help with things like budgeting and coming up with a plan to deal with your debt. They could also help you apply for debt respite schemes such as the ‘Breathing Space’ scheme in England and Wales and the Debt Arrangement scheme in Scotland. There isn’t currently an equivalent scheme in Northern Ireland.

Image source: Getty Images

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