How Do Payday Loans Work

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Last updated by Zaving Editorial Team, on January 18th, 2024

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What are payday loans and how do they work?

Payday loans are short-term loans typically aimed at bridging financial gaps between paychecks. These loans offer individuals quick access to a small amount of money, usually less than $500, to cover urgent expenses or unforeseen bills. They're often considered as a solution for individuals seeking affordable payday loans due to their relatively easy accessibility.

The process involves a borrower providing a post-dated check or authorizing an electronic debit for the loan amount plus fees, which the lender collects upon the borrower's next payday. Repayment periods for payday loans are usually short, ranging from a few days to a month, aligning with the borrower's next payday.

To obtain a payday loan, applicants generally need to demonstrate proof of income, provide identification, and have an active checking account. The approval process is usually swift, sometimes occurring within minutes or hours, making them a viable option for individuals in need of quick and low-cost payday loans.

While these loans can provide immediate relief, they often come with high fees and interest rates. If borrowers are unable to repay the loan by the due date, they may face additional fees and end up in a cycle of debt, potentially leading to higher financial strain over time.

How much do payday loans cost?

The costs associated with payday loans are primarily determined by the loan amount, interest rate, and fees.

  • Loan amount: The amount borrowed plays a significant role in determining the overall cost of the loan. Since payday loans typically involve high interest rates, a larger loan amount will result in higher interest charges.
  • Interest rate: payday loans are notorious for their exorbitant interest rates, which can range from 300% to 400% apr. These high interest rates significantly increase the overall cost of the loan, making it difficult for borrowers to repay the loan in full and often leading to a cycle of debt.
  • Fees: In addition to interest rates, payday lenders charge a variety of fees, which can substantially increase the total cost of the loan. These fees may include application fees, origination fees, late payment fees, and rollover fees.
 

To calculate the total cost of a payday loan, one can use the following formula:
Total cost = loan amount + (interest rate × loan amount × repayment period) + fees

For instance, if a borrower takes out a $300 payday loan with a 300% apr for a two-week repayment period, the total cost would be:
Total cost = $300 + (0.30 × $300 × 2) + fees

Assuming the fees amount to $50, the total cost would be $440. This means that the borrower would have to repay $440 for a $300 loan.

What are the pros and cons of payday loans?

Here are some of the pros and cons of payday loans:

Pros:
  1. Quick access to cash: Payday loans offer fast approval and funding, providing immediate financial assistance for urgent needs.
  2. Easier qualification: Payday lenders typically have less stringent qualifying criteria compared to traditional lenders, making them accessible to individuals with poor credit or no credit history.
  3. Convenient application process: Payday loan applications can be completed online or in person, offering a convenient means of obtaining the funds.
 
Cons:
  1. Exorbitant interest rates: Payday loans are notorious for their excessively high interest rates, often ranging from 300% to 400% APR, significantly increasing the overall loan cost.
  2. Numerous fees: In addition to high interest rates, payday lenders charge various fees, such as application fees, origination fees, and late payment fees, further inflating the loan's cost.
  3. Debt trap potential: The high interest rates and fees associated with payday loans can quickly lead to a cycle of debt, making it difficult for borrowers to repay the loan on time and trapping them in a pattern of accumulating debt.

More of your frequently asked questions about payday loans

Are payday loans available in all U.S. states?

No, payday loans aren't uniformly accessible across the United States. As of 2023, roughly 18 states and the District of Columbia have implemented bans on payday loans, while the other 32 states and Puerto Rico have established guidelines permitting them with varying degrees of restriction.

Can I get a payday loan with bad credit?

You could potentially secure a payday loan even if you have bad credit. Payday lenders primarily assess your income and capacity to repay rather than focusing solely on credit history. However, bear in mind that having poor credit might mean facing higher fees or interest rates.

What happens if I default on my payday loan?

The repercussions of defaulting on a payday loan extend beyond added fees and credit damage; lenders may pursue legal measures. This can severely impact your credit score and ability to secure future loans. Seeking advice from credit counseling agencies or financial advisors in times of repayment struggle can offer valuable insights and options to address the situation effectively.

What are some alternatives to payday loans?

Looking for alternatives to payday loans may involve seeking small-dollar loans from credit unions or community banks, which often provide lower interest rates. Additionally, exploring options like negotiating payment arrangements with creditors, seeking assistance from non-profit credit counseling agencies, or considering peer-to-peer lending platforms can offer more feasible borrowing solutions.