What Is a Payday Loan and How Does It Work?
A payday loan lets you borrow a small amount until your next paycheck. You usually just need to prove your income with a pay stub.
But beware: The interest can be extremely high — rates of almost 400% are not uncommon — and if you don’t repay the loan on time, you’ll face extra fees and can get stuck in a cycle of debt.
Fortunately, though, there are alternatives to payday loans, even if you have bad credit.
- Payday loans are short-term loans, usually with very high interest rates but no credit check.
- Taking out a payday loan can be dangerous, with a risk of late fees and overdrawing your bank account if you don’t have the money to repay the loan.
- Better alternatives can include credit union loans or even some credit cards.
What is a payday loan?
Payday loans are a quick but expensive way to borrow money. They tend to be for $500 or less, and repayment is due in one lump-sum payment on your next payday.
Payday loan lenders don’t usually ask for a credit check, so they’re a tempting way to borrow money if you have bad credit and just need a little cash until your next paycheck.
But payday loans tend to be extremely expensive, with interest rates well into the triple digits. Since there’s no credit check, you might borrow more than you can repay, causing you to rack up fees and forcing you to borrow again.
Payday loans are often a kind of predatory lending, with the danger of falling into a vicious loan cycle, so it’s best to consider all other alternatives first.
Payday loan lenders don’t tend to advertise costs in terms of annual percentage rate (APR) or interest rate (though they’re required to show this number somewhere in the fine print).
Instead, they advertise a flat fee — usually up to a maximum of $10 to $30 for every $100 borrowed.
If you borrow $300 for a $45 fee for two weeks, the interest would work out to almost 400%. This is far beyond even the highest-APR credit cards, which rarely charge more than 30%.
How do payday loans work?
When you take out a payday loan, you probably won’t need any kind of credit check, but you do need to give the lender a post-dated check or your banking information so it can collect the debt on your next payday.
When it comes due, the payday loan lender can take the payment directly from your account, with no need for a collection agency.
If you don’t have enough money in your account, the payday lender can charge you late fees. You could also face overdraft (or “non-sufficient funds”) fees from your bank.
In fact, the lender can try to withdraw the money multiple times, triggering multiple overdraft fees — though there have been government efforts to limit this.
If you can’t afford to repay your loan, you may have to renew it ahead of time. Renewal fees tend to be the same as what you paid the first time — so if you paid $45 to borrow $300 and need to renew, the lender would tack on another $45, for a total debt of $390.
No, payday loans do not help build your credit. Payday lenders rarely report to the credit bureaus, according to the Consumer Financial Protection Bureau.
On the other hand, if you default (fail to repay), it could end up on your credit report, damaging your credit and cutting you off from other loans.
How to get a payday loan
Payday loans are available at brick-and-mortar storefronts or from an online payday lender. Either way, the steps are usually the same:
- Provide ID: You may be asked for a government-issued ID or your Social Security number.
- Provide proof of income: This is usually done with pay stubs.
- Provide a method of payment: If you’re signing up online, you’ll likely need to give your bank account information. If you visit a storefront, you may be asked instead for a post-dated check for the amount owed.
- Sign the paperwork: Read this document carefully and make sure you understand it. It should disclose the lender’s license to work in your state, the amount you’re borrowing and the fees (including a translation of those fees into APR). If your state requires payday lenders to have a license, then this should be noted too.
- Get the cash: If you’re borrowing in person, the lender might issue the funds while you’re there. If you’re borrowing online, the lender will transfer the money electronically, which can sometimes take one to two business days.
- Repay the loan: On your next payday, the lender will either withdraw the amount owed from your bank account or cash the post-dated check you provided.
Payday loan laws vary by state. In some states, you can’t borrow online, while in others, all payday loans are illegal.
Alternatives to payday loans
Payday alternative loan
If you’re a member of a federal credit union, you may be able to get a payday alternative loan (PAL). These let you borrow between $200 and $2,000 for up to 12 months.
Some rules for PALs include:
- The application fee for a PAL can’t be more than $20.
- Repayment must be in biweekly or monthly installments for between one and 12 months.
- Rates can’t exceed 28% APR.
To get a PAL you may need to be a credit union member for at least a month. You can get up to three PALs in a six-month period, but only if none of them overlap or get rolled over.
Personal loan
A regular personal loan can also be used to tide you over, but they are usually longer term than a payday loan and come from a bank, credit union or other financial institution.
There are big differences between personal loans and payday loans. Importantly, personal loans are almost always a lot cheaper and lend you the money for a longer period of time.
Personal loans also require a credit check, although you can find personal loans for those with bad credit.
On the other hand, payday loans usually get you the money immediately, or within a day or two. Personal loans tend to take longer, though in some cases, an online lender might be able to disburse the funds by the next business day.
Credit card
Credit cards can be more expensive than many other kinds of debt. But compared to payday loans, credit card interest rates don’t look so bad.
You can avoid paying interest on purchases altogether if you pay off the balance before the end of your billing cycle.
If you need the loan to pay off other debt, you might find a balance transfer card, even with poor credit. Or you could use your card for a cash advance, though this usually comes with a higher rate than for purchases and incurs a fee immediately.
401(k) loan
It’s usually not a good idea to borrow from your 401(k), since you’ll lose out on money you may need in retirement. But in most cases, a 401(k) loan is a better choice than going to a payday lender.
Be aware that not every 401(k) plan lets you borrow from it, and there are rules on how much you can borrow and for how long.
If you can’t repay the loan, you’ll owe taxes and a penalty, unless you’re older than 59 ½ or meet other requirements. But on the upside, this won’t hurt your credit.
Paycheck advance apps
Paycheck advance apps, like Earnin or Dave, let users borrow money from their next paycheck.
If you can wait a few days, you may be able to borrow money with no fees, but instant funding usually means you have to pay a convenience fee, which can sometimes be as expensive as a payday loan.
Some apps can also get your paycheck transferred to your account early if your employer has already processed it, charging you a small fee. Early pay (or early deposit) is sometimes provided as a free service, however, when you have direct deposit of your paycheck set up with your bank.
While paycheck advance apps are similar to payday loans in some ways, they’re often better deals. Just be sure to read the fine print and figure out what you’ll be charged ahead of time.
Frequently asked questions
Yes, payday loans can ruin your credit if you can’t repay them. But even if you do repay them on time, they still won’t improve your credit.
To get a payday loan, you’ll usually need your ID and a pay stub to prove your income. You’ll also need to give your bank account information or a post-dated check, so the lender can collect when the loan comes due. If you don’t have the funds to repay the loan, you could face fees from the lender and overdraft fees from your bank.
Yes, payday loans can be hard to repay. If you need to borrow $500 or less at such an expensive rate, you may well find yourself in the same situation next paycheck, making it hard to dig yourself out of debt.
If you can’t repay your payday loan, you’ll likely be hit with overdraft fees by your bank and additional charges from the payday lender. Avoid taking out a payday loan if you think you might not be able to repay it; instead, look for alternative loans to get money fast.
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