What Is a Payday Loan & How Does It Work?

At some point, just about everybody considers taking out a loan. Loans can help potential buyers make large purchases that they otherwise couldn’t afford, or help pay for unexpected expenses like car repairs. Young adults might start off with loans to pay for college. Others might use a mortgage to buy a new house.

Payday loans are another type of borrowing option that many people have questions about. That’s why we’ve put together this short guide to help you learn the ins and outs of what they are, how they work, and whether you should consider them.

What are Payday Loans?

A payday loan is a small, short-term loan intended to cover unexpected expenses that can’t wait until you receive your next paycheck. Payday lenders typically charge a fixed fee based on the amount borrowed, and you have until your next payday to pay off the amount borrowed plus the fee.

For example, let’s say that you have an unexpected car repair of $300 that you need to pay for, but you don’t get paid until the end of next week. You need to have your car fixed before then to get to work, but you’re living paycheck-to-paycheck, as many Americans do. You can apply for a payday loan of $300 and receive the funds quickly — usually the same day or the next business day. Then when your next paycheck comes in, you’ll have to pay back the $300 loan plus the finance charge as determined by the lender.

According to LendEDU, 12 million Americans use payday loans each year, paying a whopping $9 billion in loan fees to do so.

How Do Payday Loans work?

Payday loans work by providing you with a relatively small amount of money to help you make it until your next payday. Typically, you can receive a payday loan in person or through an online lender. It’s important to note that payday loans can go by other names as well, including cash advance loans and check advance loans.

Payday lenders lend money with the expectation that you will repay the full amount of the loan when you receive your next paycheck. You may be required to write a postdated check made out to the lender for the full amount of the loan plus fees. Alternatively, you may need to authorize the lender to electronically debit your checking account. Lenders do this to ensure that they will receive their money (plus fees) after your next payday.

An important thing to know about payday loans is that there are state laws that play a big part in whether you can get a payday loan. In fact, payday loans aren’t allowed at all in some states, including Arizona, Georgia, and New York. States like Massachusetts don’t allow loans that are referred to as payday loans, but other small loans are permitted.

If your state does allow payday loans, there are still restrictions to be aware of. Most states that allow payday loans are strict about what finance charges lenders can attach to payday loans. State laws also determine the maximum loan amount and the loan terms that lenders can issue.

What Does the Payday Loan Application Process Look Like?

Using our previous example of an unexpected car repair cost of $300, let’s run through the typical payday loan application process.

Step 1: Apply

Apply for a payday loan of $300 with a $45 fee (that’s approximately a 400% annual percentage rate, or APR, for a two-week loan according to the Consumer Financial Protection Bureau).

Step 2: Get cash

After approval, the lender will provide you with $300 by depositing it into your checking account, or issuing you cash, a check (or a cashier's check), or a prepaid debit card.

Step 3: Set up repayment method

You can agree to repay the loan by writing the lender a check for $345 that they will hold until the due date, or grant the lender authorization to electronically withdraw $345 from one of your accounts on the due date.

Step 4: Repay on payday 

On the due date, the lender deposits the check or withdraws the funds as repayment for the loan.

Do Payday Loans Hurt Your Credit Score?

In most cases, payday loans won’t hurt your credit score. Most storefront and online lenders don’t perform a credit check or consider your credit reports or credit score to determine your eligibility for a payday loan. Payday loans also aren’t usually reported to the three major national credit bureaus.

That being said, if you neglect to repay your payday loan, you could see a negative impact on your credit score. If your payday lender sends your loan debt to a debt collection agency, the debt collector may report the debt to the credit reporting companies. You could also see an impact on your credit score if a payday lender files a lawsuit against you to collect the unpaid debt.

How Much Can I Borrow With a Payday Loan?

Most states that allow payday loans have a capped maximum loan amount, so the amount that you can borrow depends a lot on where you live. Loan amounts can be as high as $1,000 in states such as Delaware and Illinois, but states such as California only allow a maximum payday loan amount of $300.  States that have loan caps see this as a way to protect borrowers from the high cost and short repayment terms of payday loans.

In some cases, you may be able to take out more than one payday loan at a time. However, this is generally a bad idea as it can lead to a cycle of debt if you aren’t able to repay the amount in full without reborrowing. This is why it is not allowed in some states.

Pros & Cons of Payday Loans

There are pros and cons to weigh if you’re considering applying for a payday loan. Keep these things in mind before you go through the process.

Pros:

• Payday loans can provide you with quick cash, sometimes even within the same day that you applied.
• There aren’t many requirements to be eligible for a payday loan, so you may be able to get one even if you have bad credit.

Cons:

• State laws restrict the amount that you can borrow with a payday loan.
• Payday loans are only allowed in 32 states.
• According to the Consumer Financial Protection Bureau (CFPB), a fee of $15 per $100 borrowed is common with payday loans. “This equates to an annual percentage rate of almost 400% for a two-week loan,” says the CFPB.
• Payday loans can easily lead to an unfortunate cycle of debt due to high interest rates. If you are unable to pay back your payday loan with your next paycheck, you can ask your lender to extend your loan. Lenders often charge a renewal fee and a late fee to extend loans, adding even more to your debt. These fees can make it difficult to repay your small loan.

Review Your Options

Payday loans aren’t your only option in a financial emergency—there are several other ways to borrow money fast. For example, a personal installment loan, loan from a family member, or auto title loan might be a better fit for your personal financial situation. Here’s an overview of some of the other options that you might want to consider as an alternative to payday loans.

Paycheck advance

Not to be confused with a payday loan, a paycheck advance is something that you may be able to get directly from your employer. Some employers will allow you to receive an advance of your paycheck with no fees attached. If you need quick money to hold you over until your next paycheck, it might be a good idea to ask your supervisor about this option.

Personal loans

There are a few reasons to consider a personal loan instead of a payday loan. First, personal loans are typically available in larger amounts than payday loans. They’re also installment loans, so you can repay them with fixed monthly payments over years as opposed to the short turnaround time for repaying a payday loan. Personal loans tend to come with lower interest rates than payday loans as well.

Most lenders do take your credit score and debt-to-income ratio into consideration when you apply for a personal loan. The plus side of this is that if you repay your personal loan on time, it can help you build your credit and raise your credit score.

The Bottom Line

We can’t tell you whether a payday loan is right for you, but we can help you make sure you know all of your options if you need help making it to your next paycheck. RISE’s goal is to help you take control of your debt and improve your financial situation. If you’re in a pinch, you can apply now for a RISE loan that can help you get cash in your account as soon as tomorrow.

This content provided is for educational and informational purposes only and does not constitute financial or legal advice. RISE is not acting as a credit counseling or repair service, debt consolidation service, or credit services organization in providing this content. RISE makes no representation about the reliability or suitability of the information provided – any action you take based on this content is at your own risk.