If you’re toying with the idea of taking out a payday loan, you probably have some questions. How do payday loans work? Are they as bad of a deal as people say they are? Are there better options out there?
A payday loan is a small short-term loan a person takes out at a high interest rate with the understanding that the debt will be settled in a short amount of time. The loan amounts generally range from $100 to $1,000. (See more payday loan statistics.)
The name “payday loan” came about because often the loan is repaid when the person’s next paycheck comes in. People often turn to this type of loan, despite the high annual percentage rate, when they need money quickly and have no emergency savings.
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Taking Out a Payday Loan
First off, you’ll need to find a payday lender. Finding a business that offers this type of loan is easy because the loans are highly profitable due to the high interest rates.
Once you’ve settled upon a lender, you’ll have to meet their requirements. Often, the requirements include:
- A pay stub to show employment
- Identification to show the borrower is at least 18 years old
- A checking account at a bank
- Proof of residence in the state they are trying to get the loan in
Generally, credit checks aren’t performed for borrowers seeking this kind of loan because they usually don’t use a person’s credit report to determine how much of a loan to issue. That means payday loans won’t help borrowers improve their credit scores; they usually aren’t reported to credit reporting companies.
The interest rates depend upon which state the borrower is in. Several states don’t have limits on the rates that businesses can charge for payday loans. Rates can be as high as 500% or more for annual interest rates in certain states. Even among states with limits imposed, the annual interest can reach 36%. A few states ban payday loans altogether.
How payday loans are paid back depends upon the lender. Some will require automatic repayment, such as a personal check up front for the loan amount as well as any fees, while others require electronic consent to have the lender withdraw multiple payments from their bank account until the loan is satisfied.
What Are the Risks of Payday Loans?
Payday loans can bury borrowers in an avalanche of fees and interest if they aren’t paid back within the set loan term. There is a lot of opportunity for that to happen, because 10 to 12 million people take out payday loans each year, and many of those people take out more than one.
These types of loans can create a cycle of debt in which people take out more payday loans to pay off the prior ones they’ve borrowed. That’s especially true because payday loans are used frequently by people who don’t have other options when it comes to credit. Almost one-fourth of those who seek these loans live off of retirement income or public aid.
Although the exact amount will vary from state-to-state, a person who borrows $100 for two weeks can typically expect to have to pay off $115 at the end of that timeframe. While $15 might not seem like a lot, it is when you consider the short-term lending period and the fact that many borrowers seek bigger loans. If you borrow $500, for instance, that fee can rise to $75 for a two-week loan. That amounts to a lot of interest and fees, especially since many borrowers seek more than one payday loan each year.
Legal Status of Payday Loans
Some states no longer allow borrowers of payday loans to roll over their debt, but some states continue to let borrowers roll over their debt an unlimited number of times. Others cap the rollover amount at a low number, such as one or two times, to try to stop people from becoming stuck in a cycle of debt.
Currently, 18 states don’t allow high-cost payday loans—they have a cap ranging anywhere from 17% to 36% annual interest for these types of loans. Three of these states (Maine, Oregon, and Colorado) allow lower-cost payday lending. While borrowers will still face higher interest rates and fees with payday loans in these states, they aren’t nearly as high as many other states.
High-cost payday lending is still allowed in 32 states. But there are still some restrictions in many of those states. Washington only lets borrowers take out eight loans a year, for instance.
Bottom Line
Payday loans are frequently used by people who feel they don’t have another choice. This segment of the population can include people with bad credit and lower incomes. Younger people also seem to seek out this type of loan, whether it’s because of a lack of credit history or because of the ease and convenience of getting payday loans. Some people think getting payday loans is less intimidating than visiting a traditional bank.
While payday loans can be a quick way to get a loan, they are more expensive than alternatives such as credit cards, personal loans, and cash advances.
>> Read More: Payday loan alternatives
It can be easy to fall victim to having to take out repeated loans because of the high interest rates and fees they often charge. That’s why borrowers should always exhaust every option they have before taking out a payday loan. Other options include setting up a payment plan with a creditor, asking a relative to borrow money, securing a loan from community banks, or getting a credit union loan.