Payday Loans: How they Work

Know the facts before borrowing

Neon Payday Loan Signs
••• Eric Hood / E+ / Getty Images

Payday loans are short-term loans that often are used to get through a rough spot. However, there are very few situations in which these loans actually end up being helpful. Before you use one, make sure you understand the costs and risks.

How do they work?

Most often, payday loans are for no more than a few hundred bucks and need to be paid back within a couple of weeks. To get a payday loan, you typically write a check for the amount you are borrowing, plus a fee. You might leave the check with the lender, and they cash it once you are ready to repay.

If you can’t repay your payday loan when it comes due, you sometimes can roll it over so that the loan is extended. You don’t have to repay it, but fees keep accumulating. Some states regulate rollovers by outlawing them or limiting the number of times you can renew. Before taking out a payday loan, it's important to review the laws in the state where you live.

Payday loans are sometimes marketed as no credit check loans. You don't need good credit scores or even a credit history, and getting approved is easy relative to more traditional loans. As a result, they are popular with people facing financial difficulties.

Know the costs

In general, payday loans are significantly more expensive than traditional loans. You may end up paying an annual percentage rate (APR) that exceeds 100 percent several times over. For example, you might pay a $20 fee to borrow $100 for two weeks. Depending on all of the terms, that calculates to an APR of more than 500 percent.

Pitfalls

The main pitfall with payday loans is their cost. Due to extremely high fees, they don’t help you solve the real problem. If you’re having persistent financial difficulties, payday loans only make things worse. You’re paying an extraordinarily high rate of interest which means that your expenses are just going up. As a short-term strategy—maybe once or twice in your life, if that—payday loans might get you through a rough patch. For example, you might need an emergency repair for your car so you can get to work and keep earning income.

As a long-term strategy, payday loans will pull you under.

You also can get yourself in trouble if things get out of hand. Bouncing checks that you write to the payday loan establishment can end up on your ChexSystems file and result in overdraft charges from your bank. Banks and retailers may then be unwilling to work with you. Lenders also may sue you or send your account to collections, which will ding up your credit. If you keep stretching out payday loans, you'll pay far more in interest and fees than you ever borrowed in the first place.

What about payday loans from a bank?

Banks have moved into the payday loan industry, most likely in order to earn more revenue. While traditional bank loans that require you to qualify based on your credit, income, and assets can be a better alternative, bank payday loans are no better than any other payday loan. They may go by a variety of names, but they’re still expensive and risky.

In fact, payday loans from banks can be even worse than the loans you get at a payday loan store because the bank has access to your checking account, and you have to agree to let them pull funds from your account to repay the loan. When you borrow elsewhere, you might have more control over how and when your money leaves.

Alternatives

Instead of using a payday loan, consider some alternatives: