What Is a Payday Loan?

Definition & Examples of Payday Loans

Concerned woman looking at her lending options
•••

 Jose Luis Pelaez Inc / Getty Images

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.

Many people take advantage of the payday loans offered by non-bank companies. These companies market heavily to people who have difficulty making ends meet each month. Once you start taking out payday loans, however, it becomes easy to depend on them. Learn more about how these loans work and why you should avoid them.

What Is a Payday Loan?

A payday loan is a cash advance to cover you until your next paycheck arrives. Once you're approved, the company will lend you a small amount—usually no more than $500—which you'll have to pay back with a fee when you finally get paid.

Fees for payday loans are quite steep—they can range from $10 to $30 for every $100 you borrow. That can translate 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, or a prepaid card account
  • A job or other verifiable source of income
  • A valid ID proving you are at least 18 years old

You provide your identification, banking, and other details, and once 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 different. But they all make money through upfront loan fees and interest charges on existing loans. Payday lenders 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 over your loan for an additional fee. So 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 now 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 up customers to become reliant on them because the loan is due back quickly and the fees rack up. These requirements often make it difficult for a borrower to pay off the loan and still meet regular monthly expenses. Many borrowers have loans at several different businesses, which worsens the situation.

If you rely on the loans, this leaves you with less to spend on what you need each month, and eventually, you may find you're behind almost an entire paycheck.

While offering a quick fix, payday loans do not offer a permanent solution for money woes. If you find yourself needing a payday loan, examine your current financial situation for ways to change how you budget and plan your finances to see if you can free up any extra money.

Although tempting, taking out a payday loan to cover a nonemergency item such as a vacation or trip to the amusement park makes less sense than saving up your funds over time.

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 a typical credit card.

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

And, even though it's best to avoid using a credit card, it is still better 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. Just don't take a cash advance on your credit card, as those come with much higher rates.

Payday Loan vs. Installment Loan

When you need cash, there are many different options for how you can get it. Payday loans and installment loans are two of the more common types of advances you have probably heard of. The two couldn't be more different, 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

Break the Borrowing Cycle

If you have been using payday loans, do your best to stop immediately. Try to make partial payments on your loans so you can lower the balance and stop the cycle of rolling the loan over. Make sure that you can cover the basics at home, such as food, rent or house payment, and your utilities.

Put all of your remaining dollars to work paying off the loan. Check to see if your lender will let you make the loan payment in two installments instead of one if this allows you to pay off the debt easier or earlier.

Try making other changes to break the cycle, such as taking on some part-time work or doing something else to raise money as quickly as possible. See if you have unneeded household items you can sell, or look for short-term, weekend temp work. Since payday loans are relatively small, you may be able to raise the money within a month or two. Once you've paid off the loan, work to build up your emergency fund so you can avoid taking any future payday loans.

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 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?" Accessed Aug. 26, 2020.

  2. Consumer Financial Protection Bureau. "What Do I Need to Qualify for a Payday Loan?" Accessed Aug. 26, 2020.

  3. Federal Trade Commission. "Payday Loans." Accessed Aug. 26, 2020.