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What you need to know about payday loans

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Westend61/Getty ImagesPayday loans are unsecured personal loans that are typically repaid on your next payday. They can be a tempting option to quickly get the cash you need, but more often than not, their hidden fees and high rates can leave you trapped in debt.

You’ll generally pay between 150 and 650 percent (or more) in interest, depending on your state of residence. Furthermore, the likelihood of default on payday loans is rather high, and you could be better off using an alternative funding source to get over a financial hump.

What payday loans are

Payday loans are unsecured personal loans that you usually must repay by your next payday (or within two weeks) and generally total $500 or less. Because these loans are often a last-ditch option for borrowers with poor credit, payday loans tend to carry significantly higher interest rates than traditional personal loans and can come with a plethora of hidden fees. Because of this, payday loans are often criticized for being predatory, particularly for borrowers with bad credit.

“The best way to identify a payday loan is any time you borrow money and you pay back the entire amount at once, normally your payday,” says Jeff Zhou, co-founder and CEO at Fig Tech, which offers payday alternative loans. Additionally, most payday lenders don’t run a credit check; if the lender isn’t interested in your credit history, this could be a sign that you’re dealing with a payday lender.

How payday loans work

Payday loans can typically be obtained at a brick-and-mortar location or by applying online. They’re regulated at both the federal and state level. However, many states have laws that limit the fees or interest rates payday lenders can charge, and others have banned payday loans entirely.

Credit checks

To determine your rate and terms, the payday lender may request a hard credit check to view your credit score, although this is less common with a payday loan. The lender will also generally require proof of income and your pay date.

However, your credit score isn’t as large of a factor with payday loans because the lender has the authority to take its payment from your bank account when you get your next paycheck. That’s how payday lenders minimize their risk. They also can base the principal amount of your loan on a percentage of your predicted income.

Repayment

You can repay a payday loan in a few ways. You might give the lender a postdated check that it can deposit on your next payday. Alternatively, you can authorize the lender to take the funds from your bank account once you’re paid by your employer or receive benefits such as Social Security income or a pension.

Fees and other costs

Payday lenders don’t typically charge a traditional interest rate on their loans. Instead, they calculate fees to borrow and add them to the balance you have to repay. To illustrate, assume a payday lender charges $10 for every $100 borrowed. That means you would owe $50 in fees for a $500 loan, and the $550 would be due on your next payday.

If you can’t afford the payment when your next payday comes around, that’s when a lender might offer you a “rollover.” A rollover allows you to just pay the initial borrowing fee until your next paycheck, but you’ll still be on the hook for the original loan balance plus the fee for the rollover amount. Since many payday borrowers end up rolling their balances over because they cannot cover the full amount when it’s due, these fees can rapidly pile up. This makes it difficult to get out of the payday loan debt cycle.

Payday loans vs. personal loans

A payday loan and a personal loan have some similarities. Both are unsecured loans, which means that, unlike a mortgage or auto loan, they are not backed by collateral. However, you’ll want to be aware of a few important differences.

Borrowing terms

Personal loans typically have terms of at least a year and up to several years. A payday loan has a shorter term. It’s common for payday loans to need to be repaid in a matter of weeks. Usually, the full payment — interest and fees included — will be due on your next payday.

Amounts

A payday loan is typically for a smaller amount — usually under $500. Personal loan borrowers typically seek much more cash. As of the fourth first quarter of 2021, the average balance for a new personal loan was $7,104.

Payment

Personal loans are typically paid online monthly via direct deposit from a bank account. With a payday loan, if your check bounces or you can’t pay the full balance on the required payday, you may have to roll the loan over to the next payday, accruing more fees.

Rates

There are many types of personal loans, but most will have much lower interest rates than payday loans. Your interest rate will depend on the lender, the amount you borrow and your credit score.

Payday loans when you have bad credit

Many payday lenders do not rely on a credit check at all. They understand that most borrowers looking for payday loans typically do not have the best credit. Instead, lenders make up for the increased credit risk by charging higher interest rates and more fees.

A payday loan won’t negatively affect your credit if your payday lender doesn’t require a hard credit check and you can pay back the full amount by the required date. If your lender does require a hard credit check, you may notice that your credit score drops a few points.

However, if your check bounces or you can’t pay the full balance on the required payday, the amount could be sent to a collection agency, which negatively impacts your credit.

Risks of a payday loan

Although payday loans are convenient for fast cash, they aren’t without risks.

Steep borrowing costs

Due to the high interest rates and hidden fees, payday loans can potentially derail your financial health and credit score. “Payday loans charge a high interest rate, but the biggest risk of payday loans is the fine print,” Zhou says.

The fine print can include change fees, mandatory subscription charges or early repayment fees, which can quickly add up. To illustrate, the average consumer pays $520 in fees on a two-week payday loan for $375.

Risk of default

“The biggest danger of payday loans is when they turn from a short-term stopgap into a long-term drain on your finances,”  Zhou says. Unfortunately, only 14 percent of payday loan borrowers can’t afford to pay the loan back.

Excessive rollover fees

If you don’t have a plan to pay your payday loan off in full on the requested date, you’ll have to roll your loan over, meaning you’ll be responsible for the principal balance and additional fees and accrued interest. This is a vicious cycle that could land you in high-interest debt down the road.

Alternatives to payday loans

You might not be able to get a traditional bank loan to meet your quick-cash needs, but some of these methods to stretch your finances to the next payday might work better than a payday loan.

The bottom line

Payday loans can be beneficial under the right circumstances. A payday loan could be a great option if you have a sound financial history but just need some extra cash to cover an expense. However, remember that payday loans come with risks, and if you’re not confident in your ability to repay your debt, a payday loan could ruin your credit score or even land you in court.

Before getting a payday loan, discuss your loan options with banks and credit unions and find the best rate available. The dangers of payday loans often outweigh the benefits, so make sure you know their terms before applying.

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Written by
Hanneh Bareham
Student loans reporter
Hanneh Bareham specializes in everything related to student loans and helping you finance your next educational endeavor. She aims to help others reach their collegiate and financial goals through making student loans easier to understand.
Edited by
Loans Editor, Former Insurance Editor