What is a payday loan?

Key points

• A payday loan is a short-term, high-cost loan meant to be repaid on your next payday.
• Payday loans are easily available if you’re 18 or older, have a valid ID, a bank account and proof of income.
• However, these types of loans have an insidious history of trapping borrowers in a revolving door of debt with high fees.
• Think long and hard and know your rights before going to a payday lender.

It’s two weeks to payday and your account is almost empty — but you still have bills to pay. What should you do?

For 12 million Americans every year, the answer is taking out a payday loan. After all, you’ll pay it back next paycheck, right? Think again. Given the way payday loans work and the historic data, the odds of you paying it back on time with no issues aren’t good. And even if you do, the cost of borrowing from a payday lender is astronomical compared to more traditional credit options. Let’s take a closer look at payday loans and why you should approach them with extreme caution, if at all.

What is a payday loan?

The Consumer Financial Protection Bureau (CFPB) defines a payday loan as a short-term, high-cost loan, generally meant to be repaid on your next payday. These loans are usually for small amounts, and many states have set legal restrictions on the dollar amount you can borrow, with $500 being a common limit.

You pay the loan with a post-dated check for the total amount you owe, and the payday lender will take that amount from your account on your next payday. This means the loan has a short lifespan, usually due two to four weeks from the day you borrow. Most payday loans are meant to be paid in one lump sum, though some states don’t allow lenders to “renew” a payday loan. In this case, renewal means that you will only pay the fees and the lender will roll over the loan to a new due date.

How does a payday loan work?

Payday loans are intended to provide quick money, but the costs are extremely high compared to traditional loans. Payday lenders charge a fee per every $100 borrowed, with $15 per every $100 being a common amount. While that might not sound like much, if you do the math, that adds up to an annual interest rate of almost 400%. (For comparison’s sake, the average interest rate on credit cards is closer to 17%.)

To get a payday loan, you’ll need four basic things:

• To be 18 or older.
• A valid ID.
• Proof of income.
• A bank account or equivalent where they can deposit the funds.

And that’s if you’re able to pay it off as planned. If something goes wrong, that fee would likely be downright unaffordable. If you can’t pay back your loan when the due date comes, you might have to roll over your loan (if your state allows that). This will double the cost of borrowing, as you’ll have to pay the fees twice.

Additionally, if you don’t pay it on time, some payday lenders will charge late fees. And if they try to deposit your check and you don’t have enough money in your account, your bank could hit you with a fee as well.

Furthermore, some payday lenders issue the funds you borrow on a prepaid debit card, which can come with their own fees. All of these are excellent reasons to take a lot of time to deeply consider if a payday loan is really the best option for you when your money is tight — what might seem like a quick fix could put you even deeper in your financial hole.

What’s wrong with payday loans?

Payday loans can be extremely predatory and are illegal in 13 states. In fact, the CFPB found that even though in many states no-cost extended payment plans are required to be offered by payday lenders, very few borrowers are taking advantage of those plans. Put simply, if you aren’t able to pay your payday loan off when it’s due, you have two options: either opt for the extended payment plan at no cost, where you can pay it back in installments, or roll over the loan and pay double the fees.

Given that so many people are choosing the more expensive option, the CFPB notes that “monetary incentives encourage lenders to promote higher-cost rollovers at the expense of extended payment plans.” That is, payday lenders are pushing the more expensive option and downplaying the more affordable option because it makes them more money. In fact, on July 12, 2022, the CFPB filed a lawsuit against ACE Cash Express, a major payday lender, for hiding no-cost repayment plans from consumers and improperly withdrawing money from borrowers’ bank accounts.

Here are some more reasons why payday loans are usually a bad choice:

• Because of the high-cost rollovers, the average payday loan borrower spends $520 in fees to repeatedly borrow $375.
• A stunning 80% of payday loans are taken out within two weeks of paying off a previous payday loan.
• The average payday loan is repaid in a lump sum of $430 on the borrower’s next payday. That $430 is 36% of the average payday loan borrower’s paycheck, which leaves less than ⅔ of their paycheck for the borrower’s remaining expenses. In fact, research shows that the majority of borrowers can only afford to spend 5% of their paycheck on loan repayments and still cover their basic expenses like rent and groceries.

Payday loan alternatives

Depending on where you live, you may have access to government programs that can help you in a pinch. Some states offer temporary assistance, nutrition assistance, emergency rental assistance, utility assistance and down payment assistance programs for those in need.

You could also tap your existing assets by opening a home equity line of credit, borrowing from your 401(k) plan or reselling valuable items. If you’re a member of a credit union, you can ask your local branch about payday alternative loans which offer much lower interest rates and installment plans.

Perhaps most importantly, find a way to avoid a cash crunch of this kind in the future. Build a budget that will help you stay on top of recurring expenses like rent and groceries while putting some money aside. Having even a few hundred dollars in an emergency savings account can give you great peace of mind knowing in the future you can cover any surprise expenses.

Know your payday loan rights

When you can’t repay your loan — or even when you can — some payday lenders will make threats to try to force you to cough up the money. For instance, some have threatened to garnish borrowers’ wages — even though that’s illegal unless they have sued you and collected a court order of garnishment against you.

Another false claim some lenders might make is since they’re not located in the U.S., they don’t have to follow U.S. laws. As long as you the borrower are a resident of the United States, in most cases, they still have to comply with U.S. laws.

Sometimes a payday lender might even threaten to have you arrested for defaulting on your loan! That’s an empty threat, as you can’t be arrested for not paying back a payday loan. But the CFPB notes that you can be arrested in you’re sued and ignore a court order to appear.

And remember — many states mandate no-cost extended repayment plans. If you’re going to be late on your payday loan repayment, check your state’s laws and if you’re in a protected state, ask for a repayment plan rather than a rollover.

If you’re in a bind and you think a payday loan is the answer, think again. It might be an effective solution for you, but it has turned out to just be an endless debt spiral for many other payday borrowers. If nothing else, be sure you know your rights and fully understand the fine print of the loan you take out to give yourself the best chance at coming out ahead.