How Do Payday Loans Work? Learn the Dangers

More than 12 million Americans take out a payday loan each year. Why are they so popular? People turn to these short-term loans because they give borrowers access to quick cash in emergencies. Unfortunately, borrowers often don’t realize just how the payday loan works and whether they can truly afford to take one out.

What You Need to Know About Payday Loans

Also called cash advance loans, payday loans are typically used as a short-term solution to a financial emergency. The high-cost loans are basically a cash advance on the borrower’s next paycheck. That means the full amount of the loan, as well as any assigned fees or interest rates, is due when the next paycheck is issued from the employer. In most cases, this is 14 days; however, it can be 30 days if the income used is a government benefit, like Social Security. Payday lending is notorious for high fees and difficult repayment terms that often leave borrowers stuck in a debt trap.

How Do Payday Loans Work?

  1. Borrowers visit one of the 20,000 payday lender locations across the U.S., or the lender’s website.
  2. Customers are given a registration form to fill out that requires providing certain personal information, work details and bank account information.
  3. Lenders then ask borrowers for proof of identity and proof of income, which they use to determine eligibility.
  4. If the customer is eligible for the payday loan, the lender will provide an agreement for the loan amount, associated fees and repayment terms. Once the borrower signs the agreement, the lender will require the borrower to either provide a post-dated check for repayment of the loan or permission to electronically withdraw the loan amount from the customer’s bank account on the repayment date.
  5. The loan is then processed by the lender, and the funds are transferred into the borrower’s bank account within 24 hours. In some cases, the payday loan lender may be able to give the borrower cash before the customer ever leaves the storefront.
  6. Finally, the loan is typically paid in full on the following payday.

How Much Can I Borrow With a Payday Loan?

According to the Consumer Financial Protection Bureau (CFPB), the average payday loan borrower gets a loan for $350 with a two-week term. But depending on the laws in your state, payday loans can often range anywhere from $50 to $1,000.

Payday Loan Costs

State laws will determine how much a payday loan will cost. Fees generally range from $10 to $30 for every $100 borrowed. A two-week payday loan will usually cost about $15 per $100 borrowed.

Real-world example: If you borrow $100 for two weeks and the fee is $15, it would seem like the interest rate would be 15%. But since the loan must be repaid in two weeks, that $15 fee equals an APR of almost 400%. The typical interest rate for a credit card cash advance is about 30%.

Keep in mind that lenders must disclose the APR before you sign the loan agreement. Monitor this carefully. Some lenders charge APRs higher than 1,000%.

How To Repay Your Payday Loan

Most payday loans are repaid with one single payment on your next payday. Make sure to ask for a specific due date before you sign the loan agreement.

There are a few repayment methods a lender could require:

  • A postdated check
  • A check on your next payday
  • Payment on the lender’s website
  • An ACH transfer from your bank account

If you don’t repay the loan when it is due, the lender can electronically withdraw money from your checking account. This could lead to an overdraft if you aren’t prepared.

Unfortunately, many borrowers are unable to repay their original loan on the due date, forcing them to request a rollover loan.

What Is a Rollover Loan?

When state laws allow, payday lenders may offer to roll over your loan into a new one. This allows the borrower to only repay the fees and extend the repayment deadline. However, it also means a new set of fees.

States Where Payday Loans are Illegal

Arizona, Arkansas, Colorado, Connecticut, Georgia, Maryland, Massachusetts, Montana, Nebraska, New Hampshire, New Jersey, New Mexico, New York, North Carolina, Pennsylvania, South Dakota, Vermont, West Virginia and the District of Columbia.

Payday Loans and the Military

Regardless of state laws, if you’re a service member, payday lenders must meet specific requirements. The Military Lending Act (or MLA) stipulates the annual percentage rates (APRs) that active duty military or their dependents must pay. For example, the payday loan APR is capped at 36%. For this reason, some payday lenders refuse to offer loans to service members.

How Do Payday Loans Affect My Credit Score?

Payday lenders don’t usually run a credit check, so a payday loan application won’t appear on your credit report or affect your credit score. On the flip side, they also won’t be reported to the credit bureaus once you’ve accepted the loan. Because of this, timely repayment of the loans won’t help you boost your credit score.

However, if you don’t keep your account in good standing or it ends up being handed over to a collection agency, that will appear on your credit report, and your credit score will decrease — sometimes significantly.

Who Uses Payday Loans?

In 2012, The Pew Charitable Trusts conducted a survey that revealed that 5.5% of American adults used payday loans with ¾ of the borrowers using a storefront and ¼ using an online lender. The survey identified the following groups as the most likely to take out a payday loan:

  • White females between the ages of 25 and 44 years of age
  • Individuals without a four-year college degree
  • Home renters
  • Black Americans
  • Individuals who earn below $40,000 a year
  • Individuals who are separated or divorced

Of the Americans who took out payday loans, most had to roll over their loans for five months before paying them off. The survey found that 69% of borrowers used their loans to pay for monthly household expenses, while 16% needed them for emergency expenses.

What are the Dangers Associated with Payday Loans?

According to The Pew Charitable Trusts, Americans pay a whopping $9 million in payday loan fees each year. This may explain why 80% of borrowers, as discovered in a study conducted by the Consumer Financial Protection Bureau, aren’t able to repay their payday loan in full when it comes due 14 days later.

When borrowers cannot repay their payday loan, they are given the option to roll over the loan by paying an additional fee. This fee can be converted to an interest rate, which is typically the highest interest rate associated with any loan type. In fact, the average payday loan interest rate is 391%, according to the Federal Reserve Bank of St. Louis.

Pro tip: To determine the exact interest rate you’re paying on a payday loan, you’ll need to divide the fee by the amount borrowed. Take that figure and multiply it by 365 days before dividing it by the length of the repayment term. Multiply the result by 100, and you have your interest rate. So, if you borrowed $400 with an $80 fee and a 14-day repayment term, you’d use this formula (80/400 = .2×365 = 73/14 = 5.21×100 = 521). That means your $400 loan has a 521% interest rate.

You’ll have to pay the fee again each time you roll over your payday loan. If you couldn’t pay the fee and the loan in full the first time, chances are you won’t be able to pay it the following month either. Let’s say you rollover the loan six times. Using the above example, you would have paid $480 in interest on a $400 loan. This traps you in a vicious cycle of debt that is hard to get out of.

READ MORE: Step-by-step guide to payday loan consolidation

Other Types of Loans and Payday Loan Alternatives

Consumers will be excited to find out that a host of payday loan alternatives provide a better solution to their pressing financial needs. Here are a few of the better options:

  • Cash advance apps: These apps work much like payday loans, collecting the amount borrowed from your next paycheck. Unlike payday loans, this company does not charge interest or a single fee for its service.
  • Personal loan: These installment loans will have a longer loan term, and you’ll make monthly payments. You won’t need to repay the entire loan on a single due date. Even if you have bad credit, personal loans will have lower interest rates than what a payday lender will charge.
  • Home equity loan or line of credit: Because you’re borrowing from your home’s equity, interest rates on these loans will be significantly lower than what you’d pay for a personal loan.
  • Payday Alternative Loans: Federal credit unions offer two Payday Alternative Loans that are designed to help you out when you need it, without trapping you in a debt cycle. The PALs I loan requires borrowers to be a member of a federal credit union for one month before becoming eligible for the loan, while the PALs II loan is immediate, following membership set-up. Both loans have interest rates that are capped at 28% and include installment payments that are easy to manage.
  • Consumer credit counseling: While a consumer credit counseling agency won’t provide you with a loan, they can negotiate better interest rates on the loans you already have and help you create a budget that you can stick to. Many banks and credit unions provide credit counseling services to their clients free of charge.
  • Credit card cash advance: Although credit card cash advances tend to have high interest rates, they are still a fraction of the interest you’ll pay if you go with a payday loan. You’ll also have more flexibility when it comes to repayment.
  • Local charities and churches: Check with your area’s local charities and churches if you need help with bills or an unexpected expense. Organizations like the Salvation Army and Catholic Charities are set up with specific programs to help the members of their local community. Churches also have benevolence funds, so go ahead and give them a call and see if they can help before getting yourself further in debt with a payday loan.

READ MORE: Need payday loan help? Here are the best consolidation and relief programs

The Bottom Line

If you need a small loan, payday loans aren’t your only choice. There are plenty of other financial services that could help. However, if you absolutely must take out a payday loan, be sure to research the lenders and explore your best options. And when your immediate crisis has passed, try to stash away a few dollars a week into a savings account. That way, the next time you’re facing an unexpected expense you have a small emergency fund to fall back on.


What’s the difference between a payday loan and a title loan?

A title loan uses your vehicle as collateral, so interest rates will be slightly lower than what payday lenders charge. Title loans also allow you to borrow larger amounts of money. However, if you can’t repay a title loan, you could be at risk of losing your car.

Can You Get a Payday Loan in New Jersey?

Technically, no. New Jersey has laws in place prohibiting payday lending. However, tribal lenders are able to skirt state laws, so be particularly careful if you live in New Jersey and need a short-term loan.

Can I Qualify for a Loan with Bad Credit?

Yes! There are personal loans geared toward bad credit borrowers, and there are also peer-to-peer lending platforms that match you with people who are willing to lend you money.

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