What are payday loans & how do they work?

​​Borrowing money can be stressful, especially for an emergency. There are a lot of choices for personal loans and lines of credit. Payday loans, sometimes called cash advance loans, are one option, but they can come with unique risks and are even illegal in some states.

It pays to understand the costs and benefits when considering a payday loan. Then, you can make a plan so you aren’t rushed into a decision as a borrower if you need access to cash.

Key takeaways:

• Payday loans are short-term, high-cost loans that are intended to be repaid by your next payday. 
• They generally offer a fixed interest rate and set fees based on the loan amount.
• Typically, these types of loans do not require a credit check to obtain, but failure to repay the loan can still hurt your credit. 
• To determine whether a payday loan is right for you, it’s important to know your options and consider the risks.

A payday loan generally describes a short-term, high-cost small personal loan that’s designed to be repaid on your next pay day, usually around a two-to-four-week loan term. The terms and structure can vary by state, payday lender and individual loan. 

Payday loans are unsecured loans because they don’t require any collateral from the borrower. While payday lenders can provide much-needed funds, the FTC says it “has filed many law enforcement actions against payday lenders” for a variety of deceptive or unfair practices.

Borrowers can apply for a payday loan by filling out a loan application and submitting pay stubs. These short-term loans are usually for small amounts and often come with set fees based on the loan amount. For example, the Consumer Financial Protection Bureau (CFPB) describes a typical fee for a payday loan as $15 for every $100 you borrow. This is the same as an annual percentage rate (APR) of nearly 400% interest. For comparison, credit card interest rates typically range between 12% and 30%.

In exchange for a payday loan, the borrower usually gives the lender a postdated check for the full amount borrowed, plus fees. Or the borrower might authorize the lender to electronically withdraw that amount from their bank account on the due date.

Typically, the sooner a person can pay off a payday loan the better.

​​Payday loans offer a fixed interest rate rather than a variable interest rate. That’s because repayment of the cash loans are expected to be in the form of one lump sum. Payday lenders are required by the federal Truth in Lending Act to divulge any finance charges placed on a loan.

The CFPB warns of numerous other fees and costs associated with payday loans. These can include rollover fees if you need to extend the duration of your loan, late fees for missing a payment, overdraft and non-sufficient funds (NSF) fees if your bank account is short when the payment is processed and more.

Additional fees may be added to your loan if the funds are loaded onto a prepaid debit card.

A typical payday loan doesn’t require a credit check or proof of your ability to repay the loan. This can be part of the appeal for borrowers with no credit or those who are rebuilding credit and may not have other financing options. But according to Experian, these loans also can’t help you build your credit if they aren’t reported to the credit bureaus when you pay them on time.

However, if you’re late on payments—or if you’re unable to repay and default on your payday loan—the same might not be true. A payday lender might report your late or missing payments to the credit bureaus. In that case, it could still harm your credit scores.

Before relying on payday loans or other risky forms of credit, it’s good to consider your options. For example, credit counseling can help you with your monthly budgeting. If you have the time and resources to plan ahead, a healthy emergency savings fund is a great way to protect yourself from the unexpected.

A secured credit card is another option. Secured cards can help you build credit with responsible use. And as you build your credit, that could help you qualify for a card with extra perks in the future.

You can also consider installment loans. But it’s important to do your research to find the best and most affordable small loan to serve your needs.

Whichever option you choose, the key is to plan ahead. And if you have more questions on payday loans, the CFPB has an excellent payday loan resource page.

Q: Are payday loans secured or unsecured?

Payday loans are considered unsecured loans because they don’t involve collateral. 

Q: Is it bad to get a payday loan?

Like all loans, a payday loan may or may not be right for you depending on your financial situation and needs. The risks of payday loans are typically high costs and short terms. Some borrowers are not able to repay their loan before the payment due date. When considering a payday loan, carefully research the lender and terms and conditions of the loan to determine whether the loan is right for you.

For some, payday loans may be a good option, but there are specific risks that come with this type of loan. So it might be better to weigh your options.