What is a payday loan? What you might use one for and when to avoid them
Many Americans have a hard time saving and stretching their paycheck enough to cover all of their basic expenses. In fact, more than 60% of U.S. consumers lived paycheck to paycheck in April 2022—up 9% from the year before, according to data from PYMNTS and LendingClub.
While it’s important to have a budget in place that covers your day-to-day expenses as well as an emergency fund for when the unexpected happens, building up your savings takes time and this isn’t always an option when you’re in a bind. For many people, this could tempt them to consider a short-term solution, even if it comes at a high cost.
Enter: the payday loan.
What is a payday loan?
A payday loan is a short-term, high-cost loan someone can use to cover cash needs between pay periods and agrees to pay back once they receive their next paycheck. This sounds like a great idea in theory: You borrow a small amount, cover your immediate costs, and repay the loan in a few weeks. But payday loans are not that cut-and-dried; they come with steep fees that you should be aware of before considering one.
Because payday loans are repaid in one lump sum, there typically isn’t an actual interest rate attached. The cost of a payday loan is expressed as a flat fee that’s usually $15 per $100 borrowed, although the amount of this fee might range from $10 to $30 for every $100 borrowed, depending on your state law and the maximum amount your state permits you to borrow. However, when you crunch the numbers that flat fee amounts to anywhere from 391%–600%, according to InCharge. That’s more than 10 times the interest rates of alternative payment methods like credit cards (15%–30%), debt management programs (8%–10%), and personal loans (14%–35%).
Still, some consumers think the benefit of quick access to cash outweighs the high fees.
“A payday loan has less strict criteria for qualifying than other types of personal loans making it easier for someone with bad credit to qualify,” says Heather Comella, certified financial planner and planning success lead at Origin, an employee financial-wellness platform. “However, these loans are issued with significantly high fees relative to other types of personal loans.”
How do you get a payday loan and what should you use it for?
Payday loans are typically used for nonnegotiable everyday expenses like your rent, utilities, and groceries. Because of the high cost of borrowing these loans, they shouldn’t be considered for impulse or unnecessary purchases that you could hold off on, save up for, and purchase at a later date. You may want to consider this as a last-resort option and opt for alternative payment options that could come at a lower cost, such as getting a payroll advance from your employer or asking a friend or family member for a loan.
Applying for a payday loan can usually be done online or at a storefront payday lender. Your lender will likely ask you to provide personal identifying information, as well as some of your financial information, like your bank account number and routing number so that the funds can be deposited into your account. You’ll also need to provide a form of identification and proof of income (this helps the lender determine your ability to repay the loan and is used in place of a hard credit inquiry). Sometimes the lender may also ask you for a signed check or authorization to withdraw the funds for repayment from your bank account on the agreed upon repayment date.
Pros and cons of payday loans
Before considering a payday loan, you’ll want to weigh the potential pros and cons associated with this type of loan:
Pro: Payday loans have fewer approval requirements. For consumers with bad credit, payday loans can be one option for financing. Rather than pulling your credit report, payday lenders will verify that you are over the age of 18, have a source of income and a bank account, and can provide a valid form of ID.
Pro: Applying for a payday loan is usually a quick and easy process. “For someone in a tight financial situation, a payday loan may be attractive because it is quickly accessible and relatively easy to access,” says Comella. “Processing is available online and in some cases these loans are funded and deposited into your bank account within four hours.”
Con: Payday loans carry steep interest rates and fees. For borrowers who do not have an immediate plan for repayment, even a small payday loan could lead to unmanageable debt. “Commonly when the borrower gets to the next pay period they cannot afford to pay the original loan balance but maybe they are able to pay the $45 in fees; they’ll carry the $300 debt for another two weeks, accruing more fees,” says Comella. “Thus in a month the $300 loan has cost them $90 in fees. This compounds and grows for a borrower who lives paycheck to paycheck.”
Con: Payday loans do not help you build credit. Paying off your payday loan won’t earn you any positive points when it comes to your credit score. Most payday lenders do not consider your credit profile when determining loan eligibility. It’s also not common for them to report any information about payday loan borrowing history to the credit bureaus.
Payday loans can be a way for consumers to access cash quickly when they need to cover their immediate expenses and can’t wait until their next payday. However, these loans come at a cost and can lead to a vicious debt spiral.
“For someone in a paycheck-to-paycheck situation, a payday loan puts them into a precarious borrowing cycle given the high borrowing costs for these types of loans,” says Comella. “If a person can avoid this type of loan from the very beginning, they can likely preserve their credit to allow them to qualify for less expensive types of loans.”
EDITORIAL DISCLOSURE: The advice, opinions, or rankings contained in this article are solely those of the Fortune Recommends™ editorial team. This content has not been reviewed or endorsed by any of our affiliate partners or other third parties.