Personal Loans

What Is A Payday Loan And How Does It Work

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 10 minute read

More than 60% of Americans are forced to live from paycheck to paycheck, according to a survey conducted by PAYMENTS and LendingClub in 2021. Income in this predicament is insufficient to cover even the most basic of living costs. Even a $300 automobile repair is a major financial setback because it was not budgeted for.

Loans that are due on your next paycheck seem to be a solution, and they go by many names. You can get $300 from one of the thousands of payday loan stores across the country.

These loans seem like a good idea at the time, but they usually lead to far worse issues down the road. A person who uses these loans may find himself in a never-ending cycle of debt, paying back significantly more in interest than they first borrowed.

How Do Payday Loans Work?

Payday loans are short-term, modest loans (usually less than $500) intended to bridge the gap between paychecks. When your next paycheck arrives, you must promptly repay the debt in full.

Easy approval is one of the main selling points of payday loans. They don’t have to do a credit check or ask for collateral like a lien on your home or car. Borrowers with low incomes, few assets, and poor credit or no credit at all tend to favor these loans.

Payday loans are seen as predatory lending by many in the financial industry. These loans come with hidden fees and exorbitant interest rates that can add up quickly. There may be other charges you aren’t aware of.

Payday lenders, in particular, do not care about whether or not a customer can actually pay back the loan. Many borrowers end up in a cycle of debt because they have problems keeping up with their loan payments and have to keep renewing their loans.

Given these dangers, legislation in a number of jurisdictions has sought to prohibit payday lending entirely. Additionally, most jurisdictions that do permit them have capped how much can be borrowed in this manner.

How Do Payday Loans Perform?

Payday lending companies are often modest enterprises with brick-and-mortar locations. Pay stubs or similar evidence of regular income are typically required when applying for a loan. Your bank statement or account information must be provided as well.

Your bank and income history are inspected by the lender. If everything is in order, they will ask for your permission to make an electronic withdrawal from your account. They may require you to provide a personal check for the full loan amount plus interest, with a date that is within one business day of your next scheduled payday.

Following the completion of these steps, the payday lender will either deposit the loan proceeds directly into your bank account or hand them over to you in cash or a cheque. This may be completed in as little as 15 minutes.

You can only find some payday loan companies online. In most cases, the funds from your online loan will be deposited directly into your account. Usually, it will be delivered the next day.

How to Repay a Payday Loan

There is a lot of interest added to this kind of loan, so you’ll want to make sure you have enough cash on hand when your next paycheck arrives, which is typically within two weeks. 

Payday loans typically have high-interest rates, as much as $15 per $100 borrowed. In percentage terms, that equates to an annual percentage rate (APR) of 391.

You should expect your payday lender to seize the funds if you fail to make payment on the due date. Either your check will be cashed or the funds will be taken directly from your bank account, depending on the loan agreement. A typical method of repayment for loans obtained via the Internet is an automatic bank transfer.

If you find that you cannot repay the loan, you may go back to the loan office and renew it for an additional cost. Numerous debtors repeatedly do this, incurring ever-increasing costs.

This is actually the norm and the primary source of profit for payday loan companies. According to research conducted by the Consumer Finance Protection Bureau (CFPB) in 2021, over 60% of borrowers who took out payday loans still had outstanding balances six months later.

Auto Title Loans

Car title loans are a typical kind of payday loan. These are likewise no-credit-check short-term loans, but the vehicle is used as security. Getting one typically requires full ownership of a vehicle. However, some lending companies will approve them if your auto loan is nearly paid off.

In comparison to payday loans, the maximum amount you can borrow with an auto title loan is significantly more. Typically, you can borrow between 25% and 50% of your car’s worth from a lender for a term of 15-30 days. To get the automobile back, you’ll have to give up the title. A set of keys is often required by lenders as well.

Return the funds plus a 25% fee to regain possession of the vehicle. APR of 300% applies to a loan for a single month. The lender has the right to repossess your vehicle if you fail to make this payment. Lenders may require the use of a GPS tracking device if they wish to keep track of your vehicle.

The lender will sell your vehicle if they repossess it. Even if the proceeds of the sale are higher than the debt owed, in some places the creditor is allowed to keep it all. If you are unable to repay your title loan by the due date, you may be able to extend it for an additional term and incur additional fees and interest charges. 

In fact, title loans have a much higher incidence of this than payday loans do. The Consumer Financial Protection Bureau discovered that, after six months, over 80% of title borrowers still had outstanding balances.

Disadvantages and Advantages of Payday Loans

Loans on a borrower’s next payday are very common. Over 4% of all U.S. consumers took one out in 2019, said the Consumer Financial Protection Bureau. Borrowers should be aware of the potential dangers associated with this type of loan.

Advantages of Payday Loans

Getting a payday loan is simple, which is why so many borrowers rely on them. Financial institutions that provide payday loans provide:

  • Acquiring Financial Support Is Simple. More McDonald’s restaurants were in operation in the United States than payday lending businesses in 2017, as reported by the Consumer Financial Protection Bureau (CFPB). There are even more options for getting a loan without leaving your house if you use the internet to accomplish so.
  • There Won’t Be a Credit Check. Payday loans don’t care if you have good credit or no credit at all. To qualify, you need to show evidence of employment and a bank account. Because of this, people with poor credit can still get payday loans.
  • Without Security. Payday loans don’t require any kind of security. In any case, the lender already has your banking information as collateral, so they don’t need it. You’re free to keep the money if you don’t return it to them.
  • Urgent Funds. Cash advance loans are a quick and easy way to get cash when you need it. In as little as 15 minutes, you can get cash from a payday loan establishment.
  • Modest Renewals. Payday loans are easily renewed if you are having problems repaying them. Payday lenders actually encourage this practice since it increases the amount of money they can borrow from you in interest.

Disadvantages of Payday Loans

Payday loans’ only actual advantage is that they’re quick and easy to get. Almost no other sort of loan has worse terms. Disadvantages of cash advance loans include:

  • Extremely High Levels of Intrigue. Costs for a two-week, $100 payday loan range from $10 to $30. To put it another way, you’re looking at an annual percentage rate of between 260% and 785%. The average interest rate on a credit card is about 17%.
    Amount Due for Renewal Fees. This fee must be paid again and again if you roll over your payday loan. Over the course of just a few months, interest payments might add up to more than the principal loan amount itself.
  • Bank Charges. An overdraft fee is charged by your bank if your payday lender overdraws your account to retrieve repayment for your loan. And if they don’t succeed in collecting, you’ll have to pay a charge for your deposit to be returned. Lenders may impose additional charges for insufficient funds or late payments.
  • Collections. In most cases, payday lenders would keep trying to collect even after one unsuccessful attempt. They could attempt to charge your account many times, each time incurring additional fees. Otherwise, they will likely sell your debt to a collections firm. That will cause a lot of trouble, hurt your credit, and maybe even lead to legal action.
  • Only a Few are Available. Storefronts offering payday loans are common, but you won’t find one on every corner. Payday lending is prohibited by state law in 18 states and the District of Columbia due to interest rate limitations.
  • Limitations on the Freedom of Military Personnel. Federal law prohibits lenders from charging members of the military an annual percentage rate of more than 36%, even in jurisdictions where such high-interest loans are permissible. A common way that payday loan companies comply with this law is by simply not lending to military members.
  • Debt Revolving Door. Most people who get payday loans end up extending their loans several times. They get stuck in a never-ending spiral of debt, which can last for years. In interviews conducted by the Center for Responsible Lending, borrowers have reported losing houses, incurring hundreds of dollars in interest payments, and ultimately declaring bankruptcy.

Alternatives to Payday Loans

The opinions of people who have taken out payday loans, notwithstanding their exorbitant interest rates, are mixed. Many people who took out these loans in 2013 felt they were exploited, according to a Pew Research Center survey. 

Yet the vast majority also found that the loans brought some much-needed comfort. Thankfully, outside traditional bank loans, there are other options for emergency funding. 

Improved options could be:

  • Wage Prepayments. A salary advance can be a possibility if you ask your company. It means that you will be compensated in advance for work that you have already completed. In the case of biweekly compensation, for instance, they can provide the first installment after just one week.
  • Money-In-Hand Apps that Don’t Make You Wait. Paycheck advance apps like Brigit can be useful if your company does not offer payroll advances. These apps allow you to receive your paycheck early for a nominal price if any at all.
  • Loans for the Individual. There is typically no collateral needed to obtain a personal loan from a bank, credit union, or online lender. Compared to payday loans, the interest on these loans is substantially cheaper, and you have more time to repay. However, applicants with poor credit histories may be denied.
  • Loans for a Small Amount of Money. Existing customers of some banks can get access to specialized microloans for short maturities. Both Bank of America’s Balance Assist and U.S. Bank’s Simple Loan fall into this category. Payday alternative loans, or PALs, are a type of modest loan offered by some credit unions.
  • Loans Between Individuals Rather than Banks. Online peer-to-peer lending platforms, such as Prosper, provide another choice. If you have bad credit, you still might be able to apply. Interest rates are high but not as high as they would be with a payday loan.
  • Payment via Credit Card. Paying with a credit card rather than a payday loan will save you money. If not, you may be able to get one with bad credit. Investigate one of the various credit cards available if you have poor credit.
  • Advances in Cash. You can get a cash advance to cover expenses like rent that you can’t pay with a credit card. A cash advance on a credit card will cost you more than a traditional loan but less than a payday loan.
  • Inadequate Payments. A payday loan can help you out in a pinch if you have expenses due on Monday but don’t get paid until Friday. It may be more cost-effective to put off bill payment until Friday. If there is a cost, it may be less expensive than the interest on a payday loan.
  • Creditor Negotiations. You should try talking with the lender before taking out a payday loan to make the payments on existing debts. Bills can be made more affordable by negotiating a lower interest rate or a more convenient payment schedule.
  • Loans from a Pawn Shop. Items of great value can be pawned for immediate cash or used as collateral for a loan at a pawnshop. A high-interest rate on a loan is still preferable to the rates offered by payday lenders.
  • Friends and Family Pitch Into Help. It can be difficult to borrow money from loved ones. Though no one wants to do it, paying off payroll loans sooner rather than later is preferable. As with any loan, a formal agreement should be drawn out.
  • Help Needed Urgently. The government, religious institutions, and nonprofit organizations all provide some form of financial aid during times of need. The temporary aid is provided for things like rent, food, utility costs, and transportation to and from work. A few of them offer low-interest, short-term loans of a few hundred dollars or less.

Bottom Line

A payday loan can seem like a good idea when you’re in a bind and need money quickly. On the other hand, the high-interest rates and short repayment periods mean that you may end up paying back a lot more than you borrowed.

You should think carefully about whether a payday loan is really necessary before applying for one. Payday loans have such high-interest rates that even high-interest personal loans and credit card cash advances can seem like a better option.

Borrowing money to get by on a day-to-day basis is only a band-aid solution at best. It’s imperative that you take care of your own personal budget issues. A smarter budget might not save you this time, but it will help you avoid this issue in the future.

Concurrently, do everything you can to save up for a rainy day. Thus, the next time you’re short on cash, you won’t have to make the difficult decision of whether to pay off one bad debt or another, even worse one.

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