What are payday loans & how do they work?

Payday loans are short-term, high-cost, small personal loans that are designed to be repaid on your next payday, generally within two to four weeks. The terms and structure can vary by state, payday lender and individual loan. 

Payday loans are typically easy to get, which can make them appealing in an emergency. But they come with risks and consequences. They’re even illegal in some states.

What you’ll learn:

• Payday loans are short-term, high-cost loans that are meant to be repaid by your next payday. 

• They generally offer a fixed interest rate and set fees based on the loan amount.

• Many payday lenders don’t require a credit check, but failure to repay the loan can still hurt your credit scores. 

• To determine whether a payday loan is right for you, it’s worth considering the risks and potential alternatives.

1. Apply for the loan. Borrowers typically apply by filling out a loan application and submitting pay stubs. Payday loans are unsecured loans, so they don’t typically require any collateral. And lenders generally don’t run a credit check.

2. Provide a check or authorization. If approved, the borrower generally writes the lender a postdated check for the amount borrowed plus fees, or they provide authorization to make an electronic withdrawal from their bank account on the due date.

3. Receive the loan. The lender usually deposits the funds directly into the borrower’s bank account. 

4. Repay the lender. The borrower must repay the principal plus fees by the due date, typically within two to four weeks.

These short-term loans are usually for $500 or less, and often come with set fees based on the loan amount. The Consumer Financial Protection Bureau (CFPB) offers this example: “A typical two-week payday loan with a $15 per $100 fee equates to an annual percentage rate (APR) of almost 400%. By comparison, APRs on credit cards can range from about 12% to about 30%.”

​​Payday loan interest rates are fixed. That’s because repayment of the cash loans is expected to be made in one lump sum. Payday lenders are required by the federal Truth in Lending Act (TILA) to declare any finance charges placed on a loan. 

Payday loans tend to have high interest rates. So it makes sense to pay off a payday loan in full as soon as possible and no later than the next payday.

The CFPB warns of other fees and costs associated with payday loans, including:

• Rollover fees and extra interest if the borrower needs to extend the duration of the loan beyond the next payday

• Late fees if the borrower misses a payment

• Overdraft and non-sufficient funds (NSF) fees if there isn’t enough money in the borrower’s bank account when the payment is processed

• Additional fees associated with loading cash onto a prepaid debit card

Before relying on payday loans or other risky forms of credit, it can help to consider your options. Here are a few alternatives to a payday loan.

A personal loan is a type of unsecured installment loan you can repay over time with interest. You can apply for personal loans through banks, credit unions and online lenders.

This one takes a bit of forward thinking, but if you can manage to put aside even a small amount each week or month, you might have enough for an emergency fund when you need it.

To help you start saving, the CFPB has a PDF worksheet in its Your Money, Your Goals financial empowerment toolkit. The CFPB also has a Savings Boot Camp email course that you can sign up for. You can also use tools such as an emergency fund calculator.

Credit counseling companies are typically nonprofit groups that can offer advice and assistance to people who need help managing money. Their experienced professionals might offer services ranging from helping you create a budget to negotiating with creditors for lower repayment rates.

If you have a supportive friend or family member, you may feel comfortable reaching out to them for a small loan that can hold you over until your next payday.

Here are the answers to some frequently asked questions about payday loans.

Payday loans may offer a quick fix when you need access to cash right away, but high fees and short repayment terms can make them expensive and difficult to manage. It’s worth exploring other options that may be more flexible and may even give you a chance to build credit with responsible use. 

If you’re considering a credit card, you can check whether you’re pre-approved for a Capital One card with no impact on your credit scores.