How Do Payday Loans Work: Everything You Need to Know
8 MIN READ
Published June 27, 2023 | Updated December 15, 2023
Payday loans are short-term loans that can provide you access to immediate cash. You get the funds immediately, then repay the loan when you get your next paycheck. These are high-cost, small-dollar loans that are notorious for charging extremely high annual percentage rates. Payments are usually due in two weeks from the day you borrow.
When you're in a tough financial situation, it’s tempting to look for a quick, easy solution. Payday loans may seem simple, but they come with a steeper cost than you might have anticipated. One in five people that take a payday loan defaults on their loan. 80% of borrowers have to borrow again in 30 days.
So, how do payday loans work? Before you apply for one, it's important to know what you can expect from cost and repayment terms. If you're not careful, they may cost a lot more than you expected.
Eligibility Requirements for a Payday Loan
One of the biggest reasons why payday loans are so attractive for borrowers strapped for cash is because they're fairly easy to qualify for and allow you to receive money quickly.
All you need to qualify for a payday loan is to have a bank account in good standing, identification, and a steady source of income. The loans are offered based on the ability of the lender to collect, not on your ability to repay, so there is no income threshold required to qualify for the loan.
You don't need to have a certain credit score to qualify for a payday loan. Payday lenders don’t check your credit score to qualify you for a loan. These loans are typically attractive for borrowers that need access to funds fast, and payday lenders provide that access by forgoing the traditional credit checks used for other financial service programs.
Payday Loan Application Process
Knowing how payday loans work and the process involved can help you make an informed decision about if they're right for you. Payday loan providers are usually small credit merchants. They're offered through physical stores, but many online lenders also provide these loans.
If you're applying for a payday loan online, you’ll need to fill out an online form and upload a few documents, such as:
- Government-issued identification
- Your recent pay stub
- Proof of address
- A recent bank statement
- A pre-authorized debit form or check
Once you submit the application, the lender will review your application. If you're approved, the money can be transferred to your bank account in as little as one business day.
You can also fill out an application in-person at a payday loan merchant office. To complete the application, you must fill out a form and provide the same documents to show your income. Most lenders do not consider your ability to repay your loan or do a full credit check.
Once you're approved, you'll receive the funds in your checking account. Next, you're required to repay the loan and the finance charges before the due date, which is typically your next paycheck.
Amount Borrowed and Repayment Terms
The amount you can borrow through a payday loan will vary based on your finances and state’s laws, but typically, payday loans are small loans for less than $500. This does not mean you’ll be able to borrow the highest amount allowed by law. Lenders will ultimately decide how much you can borrow.
The average term for a payday loan is two weeks. Payday loans can cost 400% APR or even more. Finance charges for payday loans can range from $15-$30 for every $100 you borrow. Two-week loans can result in an APR of 390%-780%, while these interest rates can be even higher in states that do not have a cap on the maximum cost of payday loans.
Other than high-interest rates, be wary of the other high fees that your payday loan lender may charge. If you fail to repay the loan in full on your due date, a fee will be added to your loan amount, and the cycle will continue to repeat. You can end up owing a lot more in interest than your original loan amount within a few months.
Many payday lenders or short-term loan companies will also get a postdated check from you when you apply for a loan. If you do not have enough funds in your bank account when the check is cashed, you may face expensive bounced check fees and overdraft fees from your bank. Your lender may also charge failed or returned payment fees. When added to your already high payday loan interest rates, all of these extra fees can make payday loans difficult to repay if you're already in a financial crisis.
Risks and Benefits of Payday Loans
Payday loans can be risky, especially if you're not aware of how they work, the costs they involve, and their disadvantages. “PayDay loans are expensive, and once you take one out, it's a debt cycle that’s hard to break, and you can be trapped,” warns Teresa Dodson, debt expert and CEO of Greenbacks Consulting.
Take these pros and cons into consideration before you make a decision to take out a payday loan.
Despite the well-known negative consequences of payday loans, here are a few reasons why many people turn to them in times of need:
The Federal Trade Commission recommends borrowers try to find an alternative to payday loans. If you must take out a payday loan, limit the amount you borrow, so you can afford to pay it off with the next paycheck. Here are a few additional risks to consider:
- Payday loans and car title loans are very expensive.
- They are considered to be predatory loans and bad debt.
- They don’t help build credit.
- You can be sued by a lender if you fail to repay the loan.
- If you roll over a payday loan, it is easy to get into an expensive debt cycle.
How to Avoid Debt Traps
Although payday loans are meant to help you cover unforeseen costs when you have a cash shortage, it has become a very expensive lifeline for many Americans struggling financially. For many borrowers, it makes their financial situation much worse. Even if you are borrowing with the intention of paying it back, you may find yourself short again and forced to take out another loan to cover the first one. But it is possible to borrow responsibly and get out of debt.
If the due date for your payday loan is fast approaching, and you do not have the funds to pay it off, first try approaching your lender for payday loan payoff assistance. Ask for an extended payment plan, so you can get more time to clear your debt. Many lenders offer an extended payment plan through which you can get more pay periods to pay off your loan without adding interest or more fees.
In addition, a payment plan will not be handed over to a collection agency if you continue to make payments for each pay period. Some credit unions also offer an alternative to payday lending through small-dollar loans at lower interest rates.
Before you apply for a payday loan, create a budget to ensure you’ll be able to repay the loan by your next payday to avoid getting sucked into a debt cycle. Create a detailed list of all your expenses along with your expected income before the due date.
After accounting for all your necessary expenses, such as housing, groceries, transportation, and utilities, check if you will have enough funds left to pay off your loan once your paycheck comes. If not, it’s best to avoid borrowing funds. You can even try to temporarily cut back on discretionary spending, such as dining out and entertainment, and use those funds to pay off your loan. You can even consider cash advances to pay off your payday loan.
Know How Payday Loans Work to Avoid a Cycle of Debt
Payday loans can cover your short-term expenses and are easily available. The catch here is that these loans come with very high-interest rates and fees. Knowing how payday loans work can protect you from predatory lending and the many pitfalls that come with it.
Consider safer personal loan alternatives first. If you've already accumulated a lot of debt through high-interest payday loans and credit cards, consider debt relief options such as consolidation loans with bad credit, which are installment loans with a fixed monthly payment at a much lower interest rate.
TurboDebt can help you get out of the cycle of debt through consultation, planning, and debt relief services. Our experts can help you find the right debt relief option based on your financial situation. Connect with us today for a free consultation. Read our reviews to see how our debt relief services have helped thousands of clients.