What Is a Payday Loan?

Concerned woman looking at her lending options
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 Jose Luis Pelaez Inc / Getty Images

DEFINITION

Payday loans are a type of cash advance designed to help you make it to your next paycheck. Although they're usually for small amounts, they are one of the most expensive loans available.

Definition and Example of a Payday Loan

A payday loan is a cash advance of a portion of your next paycheck. Once approved, the company will lend you a small amount—usually no more than $500—and charge you fees for using its services.

For example, suppose you're short on funds one month and can't pay your rent, so you go to a payday lender and apply for enough to help you make the payment. The lender approves your loan and charges you $15 for every $100 it gives you. You get $400 to help you pay your rent, so you owe the lender $460.

Fees for payday loans are quite steep—they can range from $10 to $30 for every $100 you borrow. That translates to an APR of 400% or more, compared to credit cards, which usually have an APR of around 20% on the high end.

How Does a Payday Loan Work? 

Payday loans have a simple application process and very few requirements. They will typically look to see that you have an active account with a bank or credit union, a prepaid card account, and a job or other verifiable source of income.

You provide your identification, banking, and other details. Once you're approved, you usually receive your loan funds within 24 hours.

Payday loan companies operate under a wide variety of titles, and each one's system for loaning and collecting money may be unique. They all make money through upfront loan fees and interest charges on existing loans. They may take postdated checks as collateral to deposit on your next payday (or another agreed-upon date).

Payday lenders often offer the option to roll your loan over for an additional fee. If you pay $30 for a $200 loan and then roll that loan over when it's due, you'd have an additional $30 fee, meaning you'd owe $260.

Many states have been working on passing regulations to place caps on the allowable interest rates and help out consumers that rely on these loans.

The Dangers of Payday Loans

Payday loan companies can set customers up to become reliant on them, because the loans are due quickly, and the fees can continue adding up. These requirements often make it difficult for a borrower to pay off a loan and meet regular monthly expenses. Many payday loan users have loans from several different businesses, worsening their financial situation.

If you rely on these loans, you're leaving yourself with less and less every month to cover your expenses; eventually, you may find that you're behind an entire paycheck or more.

Alternatives to Payday Loans

In most cases, it's best to avoid payday loans at all costs. If you need financial help, investigate other sources first. Some credit unions and banks have begun to offer a similar service of small salary-advance loans but at interest rates much closer to those of a typical credit card.

It's worth checking to see whether you can get a salary advance through your employer. Your boss may be more understanding than you think.

Even though it's best to avoid using a credit card, it is still less expensive than taking a payday loan. A credit card gives you more time to pay back the money, with additional flexibility on how you choose to break up the payment. If you can pay the card off in just a few months, you can keep yourself safe from the expensive payday loan cycle. And while cash advances carry high interest rates, even those are less costly than payday loans.

Payday Loan vs. Installment Loan

When you need cash, there are many different options for getting it. Payday and installment loans are two of the more common types of advances—the two couldn't be more different, though, and installment loans are the much safer option if you have access to them. Here are just a few of the differences:

Payday Loans Installment Loans
Usually for a small amount Can be for anything small or large (e.g., auto loans or mortgages)
Extremely high APR APR depends on the loan type but always much lower
Minimal requirements More requirements in terms of income, credit score, other debt
Can often be rolled over for additional fees Payback is done over a set period, can't be rolled forward
Borrowers can become dependent on them to make ends meet Not designed to depend on them indefinitely

Key Takeaways

  • Payday loans are small cash advances meant to help you make it to your next paycheck.
  • They are usually easy to get, but they come with very high fees.
  • Many people get trapped in a cycle of payday loan debt because they can continue to roll the loan over for additional fees.
  • There are many better options than payday loans for covering your financial needs.

Article Sources

  1. Consumer Financial Protection Bureau. "What Is a Payday Loan?"

  2. National Conference of State Legislatures. "Payday Lending State Statutes."