How do Payday Loans Work?

Payday loans are taken out by over 12 million Americans each year, says The PEW Charitable Trusts. These short-term loans are popular because they give borrowers access to quick cash in emergencies. Unfortunately, borrowers often don’t realize just how the payday loan works, and whether they can truly afford to take one out.

What are payday loans?

Often called cash advance loans, payday loans are typically used as a short-term solution to a financial emergency. The loans are basically a cash advance on the borrower’s next paycheck. That means the full amount of the loan, as well as any assigned fees or interest rates is due when the next paycheck is issued from the employer. In most cases, this is 14 days, however, it can be 30 days if the income used is a government benefit, like Social Security.

Who uses payday loans?

In 2012, The PEW Charitable Trusts conducted a survey that revealed 5.5% of American adults used payday loans with ¾ of the borrowers using a storefront and ¼ using an online lender. The survey identified the following groups as the most likely to take out a payday loan:

  • Caucasian females between the ages of 25 and 44 years of age
  • Individuals without a four-year college degree
  • Home renters
  • African Americans
  • Individuals who earn below $40,000 a year
  • Individuals who are separated or divorced

Of the Americans that took out payday loans, most had to rollover their loans for a total of five months before they were able to pay them off. The survey found that 69% of borrowers used their loans to pay for monthly household expenses, while 16% needed them for an emergency expense.

How do payday loans work?

  • Borrowers visit one of the 20,000 payday lender locations or visit the lender’s website.
  • Customers are given a registration form to fill out that requires providing certain personal information, work details and bank account information.
  • Lenders then ask borrowers for proof of identity and proof of income, which they use to determine eligibility.
  • If the customer is deemed eligible for the payday loan, the lender will provide an agreement for the loan amount, associated fees and repayment terms. Once the borrower signs the agreement, the lender will require the borrower to either provide a post-dated check for repayment of the loan or permission to electronically withdrawal the loan amount from the customer’s bank account on the date of repayment.
  • The loan is then processed by the lender and the funds are transferred into the borrower’s bank account within 24 hours. In some cases, the payday loan lender may be able to give the borrower cash before the customer ever leaves the storefront.

What are the dangers associated with payday loans?

According to The PEW Charitable Trusts, Americans pay a whopping $9 million in payday loan fees each year. This may explain why 80% of borrowers, as discovered in a study conducted by the Consumer Financial Protection Bureau, aren’t able to repay their payday loan in full when it comes due 14 days later.

When a borrower isn’t able to repay their payday loan, they are given the option to rollover the loan by paying an additional fee. This fee can be converted to an interest rate, which typically is the highest interest rate you’ll find associated with any loan type. In fact, the average payday loan interest rate is 391%, as stated by the Federal Reserve Bank of St. Louis.

To determine the exact interest rate you’re paying on a payday loan, you’ll need to divide the fee by the amount borrowed. Take that figure and multiply it by 365 days before dividing it by the length of the repayment term. Multiply the result by 100 and you have your interest rate. So, if you borrowed $400 with an $80 fee and a 14-day repayment term, you’d use this formula (80/400 = .2×365 = 73/14 = 5.21×100 = 521). That means your $400 loan has a 521% interest rate.

Every time you rollover your payday loan, you’ll have to pay the fee again. If you couldn’t pay the fee and the loan in full the first time, chances are you won’t be able to pay it the following month either. Let’s say you rollover the loan six times. Using the above example, you would have paid $480 in interest on a $400 loan. This traps you in a vicious cycle of debt that is hard to get out of.

Payday loan alternatives

Consumers will be excited to find out that there are a host of payday loan alternatives that provide a better solution to their pressing financial needs. Here are a few of the better options:

  • The Earnin app: The Earnin app works much like a payday loan, in that it collects the amount borrowed from your next paycheck. Unlike payday loans, this company does not charge interest or a single fee for its service.
  • Payday alternative loans: Federal credit unions offer two payday alternative loans that are designed to help you out when you need it, without trapping you in a debt cycle. The PALs I loan requires borrowers to be a member of a federal credit union for a period of one month before becoming eligible for the loan, while the PALs II loan is immediate, following membership set-up. Both loans have interest rates that are capped at 28% and include installment payments that are easy to manage.
  • Consumer credit counseling: While a consumer credit counseling agency won’t provide you with a loan, they can negotiate better interest rates on the loans you already have, as well as help you create a budget that you can stick to. Many banks and credit unions provide credit counseling services to their clients free-of-charge.
  • Credit card cash advance: Although credit card cash advances tend to have high interest rates, they are still a fraction of the interest you’ll pay if you go with a payday loan. You’ll also more flexibility when it comes to repayment.
  • Local charities and churches: Check with the local charities and churches in your area if you need help with bills or an unexpected expense. Organizations like the Salvation Army and Catholic Charities are set up with specific programs to help the members of their local community. Churches also have benevolence funds, so go ahead and give them a call and see if they can help before getting yourself further in debt with a payday loan.