What Are Payday Loans and How Do Payday Loans Work?

A payday loan is a unique type of short-term loan that is typically extended against a high-interest rate. It gets its name from the idea that a person might need a quick cash advance to tide them over through the end of the month until payday. Usually, a portion of the borrower’s next paycheck serves as the loan’s principal. 

The below guide provides more essential details to the question “what is a payday loan and how does it work?” and explains why you might need one.

What Is a Payday Loan?

A payday loan is a short-term loan that you can take out efficiently and repay after you’ve received your next paycheck. Part of your salary will usually serve as the loan’s principal. Ideally, you will pay back the loan within two to four weeks once you get your paycheck. 

A typical payday loan will be relatively small, with loan limits usually set at a maximum of $500. Payday loans are also unique because they often don’t require a credit check. This makes them an ideal option for people with bad credit or limited credit history.


How Do Payday Loans Work?

You’re probably wondering, “how do payday loans work?” Small credit merchants provide most payday loans. Many will have brick-and-mortar storefront locations where you can walk in to complete your loan application in person. We explain how the application process works below.

Limits on Payday Loans

Payday loans are heavily regulated in most states. Some states don’t allow them at all. Limits for payday loans are generally small. In Delaware, limits on payday loans are set at $1,000, for example, while in California, the limit is just $300.

Interest Rates on Payday Loans

As mentioned, payday loans tend to have high-interest rates. Even with state regulations, these rates can be as high as 40%. Compare this to the average personal loan interest rate of about 36% (even for borrowers with low credit scores). That’s a considerable divergence!

Repayment Period for Payday Loans

In addition to high-interest rates, another issue with payday loans is the repayment period. Personal loans let you repay the money you owe over a month-long period. However, payday loans expect the cash back more quickly, usually within 14 to 31 days after taking out the loan. 

This can be extremely difficult for people who are living paycheck-to-paycheck. If they extend their repayment period, they end up with additional interest and fees, making it even harder to pay back.

A vicious cycle can result. Some people end up borrowing even more money to pay back the initial loan, resulting in even more finance charges.


A Payday Loan Example

To give you an idea of just how these loans can add up, here’s an example. Say you borrow $500 through payday loans. You have to pay a fee of $15 for every $100 borrowed. So that’s an added $75 of costs on your $500 of funds borrowed.

However, you also have to calculate your annual percentage rate, APR. This is calculated daily. So if you borrow $500 for a full term of 31 days, you will face an APR of 176%.

Where Can You Get a Payday Loan

You can take out a payday loan in-person or online. This is assuming that your state permits payday loans, which not all do. Here’s what the process looks like:

  1. You will have to complete an application with the necessary details like your name and address.
  2. You will need to present a valid form of identification showing you are 18 years of age.
  3. You will need to have a credit union, checking account, similar bank account, or a prepaid card account.
  4. You will need to show you have a job or a similar source of verifiable income.
  5. To use your next paycheck as principal, you will have to show pay stubs from your current employer towards this end.
  6. In some cases, a credit check may be required.
  7. Next, you will have to write a postdated check for the amount you will borrow, plus fees and interest. This guarantees the lender gets paid by your next payday.

You will then get the money you are owed. The loan may be provided in the form of a check or cash or electronically deposited into your account. Alternatively, the lender may load the sum onto a prepaid debit card.

The process is fast and straightforward and generally more efficient than the procedure needed to take out a personal loan, credit card, or similar funding.

A girl holding money.

What Happens If You Can’t Repay Your Loan on Time

If you cannot pay back the money owed by the intended due date, check with your lender. You may be allowed to renew or rollover your plan, allowing you to extend the due date. Beware, however, that this will accrue additional interest and penalty fees.

A Word of Warning About Predatory Lenders

Payday loan lenders tend to prey on vulnerable individuals who are in dire need of funds. Predatory lenders take advantage of desperate people who need cash and have bad credit or no credit report.

To keep consumers safe, many states have become more vigilant about regulating payday loans. Some don’t allow them at all. States permitting payday loans regulate details like the terms, finance charges, and maximum loan amount.

Regulation Surrounding Payday Loans

Different states have different rules regarding payday loans. The Consumer Financial Protection Bureau (CFPB) recommends checking with your state’s financial services regulator or state attorney general to see what legislation is in place where you live.

The CFPB is a federal agency that works to ensure lenders, banks, and similar financial institutions treat consumers fairly. The U.S. agency has online guidance you can use to determine whether a payday lender is legitimate in your state.

Here is a list of regulators state-by-state. If you are looking for your state’s attorney general, consult the National Association of Attorneys General’s database. Again, you can search state-by-state to find the correct regulatory body in your area.

Where are Payday Loans Banned In the U.S?

As of 2020, the District of Columbia and 12 states have banned payday loans. Here are the 12 states where payday loans are prohibited:

  • Arkansas
  • Arizona
  • Connecticut
  • Georgia
  • Maryland
  • Massachusetts
  • New Jersey
  • New York
  • Pennsylvania
  • North Carolina
  • Vermont
  • West Virginia

If you live in any one of these states or Washington D.C., and you see local payday loans advertised, beware! These are illegal and not legitimate. You are dealing with a predatory lender who is engaging in criminal activity.

This poses a greater risk to you as a consumer. If you take out an illegal loan and get scammed, your legal recourse options will be more limited.

About  the Truth in Lending Act

The Truth in Lending Act is a piece of federal legislation designed to protect consumers against predatory lenders. It requires payday lenders to share with you their finance charges. However, many consumers overlook these terms and fail to realize just how much they will face in fees. 

The Federal Trade Commission, FTC, passed this legislation. Since it was first established, it’s been amended to include payday loans and other types of lending, like credit cards and mortgages.

What Are the Pros and Cons of Payday Loans?

Payday loans are easier to get than personal loans. However, they have drawbacks. Below, we summarize some of the pros and cons of these loans. 

Here are the benefits:

  • A quick source of cash.
  • Fast and easy application process.
  • No credit check is needed. 

Here are the drawbacks:

  • High-interest rates.
  • Short repayment periods.
  • Exorbitant fees and penalties.
  • Dangers of predatory lenders.

A girl celebrating at her computer.

Who a Payday Loan is Right For

The dangers aside, payday loans can still be beneficial and useful for many consumers. The key is to find a reliable, reputable, and trustworthy lender and read any loan agreement’s fine print before signing.

If you take out a payday loan, prioritize prompt repayment to avoid getting caught in the vicious cycle of delayed payday loan repayments and heaping on late fees (and more interest). If you have no credit history or a bad credit rating and need cash to cover essential expenses like food, gas to get to work, or rent, a payday loan is a viable option.

Alternatives to Payday Loans

If you need funds quickly, there are alternatives to payday loans. You can look into a personal loan or credit card, for example. The interest rates on these alternatives are likely to be lower and more manageable. Additionally, you can arrange for a more extended repayment period. 

Another option is to borrow money from family or friends. If you go this route, it’s smart to write down the “terms” of the loan in advance (such as how much interest you will pay on the money you borrow). This ensures clarity for all involved and can help avoid tension or disputes. 

These alternative options allow you to forego the hefty fees that accompany payday loans. They will also have lower interest rates. A credit card will usually have an APR of less than 30%, for example. This makes it a less high-risk emergency fund to tap into.

A loan agreement.

Frequently Asked Questions About Payday Loans

You probably arrived at this guide because you were wondering, “what are payday loans, and how do payday loans work?” The above guide covers a lot of information. To keep things simple, we’ve broken down the highlights into this quick FAQ.

What Is a Payday Loan and How Does It Work?

A payday loan allows you to get a quick cash loan using your upcoming paycheck as the principal. Many payday loans don’t require a credit check.

Why Would You Get a Payday Loan?

A payday loan can be helpful if you are in a pinch cashwise and need quick funds to get through until your next paycheck. You may opt for a payday loan if you don’t qualify for a personal loan (for example, due to bad credit history).

What Is the Lending Limit for a Payday Loan?

Payday loans are meant to be relatively small, and lending limits are usually set at about $500. Different states have different regulations regarding payday loans, loan limits, fee amounts, and more.

How Is a Payday Loan Different From a Personal Loan?

Payday loans are faster and easier to get than personal loans, as they rarely require credit checks. However, you will face higher interest rates and fees and have to pay the money back more quickly.

When Do You Have to Pay Back a Payday Loan?

Most payday loans expect you to pay back the loan’s cost, plus interest and fees, within 14 to 31 days from the date you take out the loan. Theoretically, you should pay back the sum with your next paycheck.

Where Can You Get a Payday Loan?

You can apply for payday loans online or in-person, depending on the state you live in. Payday loans are banned in Washington D.C., and 12 states: Pennsylvania, Arkansas, Vermont, Arizona, North Carolina, Connecticut, Georgia, Maryland, Massachusetts, West Virginia, New Jersey, and New York.

The Final Word About Payday Loans

The above guide answers the question, what is a payday loan. It’s essential to do your research when taking out such a loan. While this can be a viable option for fast cash if you are in a desperate financial situation and need to cover essential living costs, there are drawbacks.

First, such cash advance loans tend to have very high-interest rates and additional fees. Second, payback periods tend to be short. You don’t want to get trapped in a cycle of debt if you can’t pay back your borrowed money on time.

Finally, state laws vary, and some states don’t allow these high-interest small loans at all. Other states have legislation to regulate payday lending, trying to protect consumers with loan and interest rate caps.

If you decide that a payday loan is the right option for you, take the time to do your research. Ensure these high-cost loans are legal in your state and find a reputable lender you can trust when taking out payday loans. The added protection you’ll get from doing your research is well worth it.

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Riley Draper