How Do Payday Loans Work?


Payday lending often gets a bad rap for taking advantage of people with bad credit by providing short-term, high-interest loans. But for many people, taking out a payday loan seems like the only option when they are cash-strapped and don’t have other credit available to help out.

payday loans

With payday lenders available both in stores and now online, getting a payday loan is easier than ever. Before you take out that loan, however, it’s important to understand exactly what a payday loan is and how it really affects your wallet. Make sure you have all the information before making any financial decisions, especially when it comes to payday lending.

What are payday loans?

A payday loan is a small loan amount borrowed for a short period of time, usually until your next paycheck. Most people use payday loans, sometimes called cash advance loans, to help tide them over when their income falls short of their monthly bills. Some people also use them to cover an emergency like a car repair or medical bill.

The most common loan term is just two weeks. The maximum loan limit is generally $500 or less. However, some places may allow loans up to $1,000. What attracts most people to payday loans is that you don’t need good credit to qualify.

However, they’re not a long-term solution to financial troubles. If you are unable to repay the loan, you’re charged a high refinancing fee that grows each time you renew any portion of the loan amount.

How does a payday loan work?

Even though you don’t need good credit for a payday loan, you do have to go through an application process either online or in person. Upon approval, you can give the lender a check predated for the loan’s due date (usually your next payday).

Alternatively, you can provide access to your bank account and authorize the lender to withdraw the loan amount on the due date. If you can’t pay the owed amount in full, you can roll over the loan into a new one.

You typically have to pay the original fee, and you’ll also be charged a new fee for the rollover loan. It’s important to communicate any changes to the original loan terms with your lender as soon as possible. This is so they don’t withdraw cash from your account that either isn’t there or is needed for something else.

Who is eligible for a payday loan?

Your credit score isn’t an issue when applying for payday loans. However, several other qualifications you must meet to get a payday loan. First, you need to live in a state where payday loans are available.

Some states ban them altogether, while others implement certain restrictions on them. Established payday lenders will provide you with this information, but it’s always smart to do your own research to make sure you’re not being scammed. Start by checking with your state banking agency, which regulates payday lenders.

Steady Income

If payday loans are legal and available in your area, you must prove that you have a steady income. The money doesn’t have to come from a job. It can also come from government benefits, alimony, or other regular income sources.

Be prepared to submit copies of pay stubs, bank statements, or a benefits rewards letter from the government to meet this requirement.

Personal and Bank Account Information

You’ll also need to provide your lender with your Social Security number and your bank account information. Because of the payday loan process, you generally can’t get a loan unless you meet these basic standards.

Other minor requirements vary lender by lender, but you can also expect to supply a valid phone number. You must be at least 18 years old, although some states carry a minimum age of 21.

Pros of Payday Loans

If you live in an area with brick and mortar payday loan stores, you can usually get money the same day you go in and apply. You can also save yourself a trip and apply online. You can sometimes get same day cash this way if you apply by a certain time, but you may have to pay an additional fee.

Another benefit is that lenders don’t check your credit report during the application process. You don’t have to worry about your poor credit holding you back or deal with an extra inquiry staying on your credit report for the next two years.

Here are some other advantages of payday loans:

  • Quick access to funds: Payday loans provide fast access to funds when you need money quickly. Depending on the payday lender, you may be able to access your loan within one business day.
  • Simplicity: Payday loans are relatively easy to qualify for and can be obtained without a long application process.
  • No credit check: Payday lenders typically do not require a credit check or minimum credit score for approval. This makes them accessible to a wide range of borrowers.
  • No collateral required: Payday loans are unsecured and do not require collateral. This makes them an attractive option for people who do not have any assets to use as collateral.
  • Flexible repayment options: Some payday lenders offer flexible repayment options, which can help borrowers stay on track with their payments.

Cons of Payday Loans

Despite the relatively easy approval process, there are several downsides to getting a payday loan. Most notably is the expensive interest rate attached to them. For every $100 borrowed, you’ll be charged between $15 and $30.

Plus, many payday borrowers end up rolling over their loans and quickly owe more in fees than their original loan amount. In a nutshell, it’s easy to get trapped in a vicious payday loan debt cycle. Even if you do repay payday loans on time, those payments aren’t reported to the credit bureaus. So, your positive financial behavior goes unrewarded.

Here are some other disadvantages of payday loans:

  • High interest rates: Payday loan interest rates are typically much higher than other types of loans, which can make them difficult to pay back.
  • Potential for debt cycle: Payday loans can be easy to get, but it can be difficult to break out of the debt cycle caused by taking out too many loans.
  • Repayment problems: Payday loans often have strict repayment requirements, which can make it difficult to pay back. According to the Consumer Financial Protection Bureau, 80% of payday loans don’t get paid back in two weeks.

Usury Laws

All states have different types of usury laws that regulate what type of loan terms a payday lender can offer. Some states have extremely strict usury laws that completely outlaw payday lending.

These include Arizona, Arkansas, the District of Columbia, Georgia, and North Carolina. Others provide varying restrictions on how much interest may be charged, how much may be borrowed, and how long the repayment period can last.

The following states don’t technically outlaw payday loans but hold all personal lenders to the same standards: Connecticut, Maryland, Massachusetts, New Jersey, New York, Pennsylvania, Vermont, and West Virginia. All other states are more relaxed with their payday lending laws.

Some have a maximum loan term, while others allow open-ended terms. Others regulate the maximum loan amount on these high-interest loans, ranging between $300 and $1,000.

Oregon is the outlier with a whopping $50,000 cap on payday loans, although the interest rate limit is 30%. Check out the restrictions in your individual state, so you know what to expect when applying for a payday loan.

What are some alternatives to payday loans for people with bad credit?

Payday loans are generally not recommended and should only be used as a last resort. Before getting a payday loan, you may want to try these options first.

  • Credit builder loans: These are installment loans with fixed monthly payments designed to help people with bad credit build their credit score. The payments you make toward your credit builder loan will be reported to the three major credit bureaus and can help you build credit.
  • Credit union loans: Credit unions are often more willing to make loans to people with bad credit than traditional banks. Credit unions may offer better terms and lower interest rates than payday lenders.
  • Secured loans: Secured loans allow borrowers to use an asset as collateral, such as a car or home, to secure the loan. This reduces the risk to the lender and may allow them to offer lower interest rates and better terms than payday lenders.
  • Personal loans: Personal loans can be a viable alternative to payday loans for those with bad credit. Some online lenders offer bad credit loans that have better rates and terms than payday loans.
  • Peer-to-Peer Lending: P2P lending platforms allow you to borrow money from individuals instead of banks or other traditional lenders. This can be a great way to secure a loan with better terms and lower interest rates than a payday loan.

How can you avoid taking out a payday loan?

Taking out a payday loan comes with a large degree of risk, particularly if you’re unsure about whether you’ll be able to repay the loan when it comes due. The best way to avoid taking out a payday loan is to increase your credit score and qualify for better loans.

See also: What Are the Best Payday Loan Alternatives?

Pay Your Bills on Time

Paying your bills on time and paying down debt are the most reliable ways to raise your credit scores. If your report has several negative items, consider fixing your credit by disputing any of those items that may be inaccurate.

Improve Your Credit Score

While improving your credit score is the best long-term solution, there are other options to explore when you need money fast but don’t want a payday loan. You can take advantage of your bank account’s overdraft protection. Even though there is a fee involved, it’s usually less than those associated with a payday loan.

Negotiate with Current Creditors

You can also attempt to lower your monthly bills by negotiating your interest or repayment period with your current creditors. You may need to show why you can’t afford the current payments.

Tap Into Savings

Consider tapping into your savings account or even asking a trusted friend or relative for a short-term loan. We all need help sometimes, and it’s wise to avoid payday loans as much as possible.

Taking out a payday loan may seem like a quick fix to your financial problems, but be sure to proceed with caution.

Final Thoughts

When you don’t have enough cash to repay the loan after a few short weeks, then you’re likely to be stuck with exorbitant fees that continue to accumulate. Payday loans are typically for a few hundred dollars or less, so you can easily double or triple your loan amount.

Fully explore your other short-term solutions before deciding on a payday loan. Once you’ve taken care of your immediate financial needs, evaluate what you can change to avoid future money crunches. Work on improving your credit and re-work your budget to cut costs and save money.

Lauren Ward
Meet the author

Lauren is a personal finance writer who strives to equip readers with the knowledge to achieve their financial objectives. She has over a decade of experience and a Bachelor's degree in Japanese from Georgetown University.