What is a payday loan?

Understanding payday loans

Payday loans advance borrowers a small amount of cash, typically between $50 and $1,000, with the agreement that the loan will be paid back in full when the borrower receives their next paycheck. You may also find these loans going by other names like short-term loans, payday advances, salary loans, payroll loans, small-dollar loans and cash advance loans.

The purpose of payday loans is to provide quick financial relief for those in need of cash. However, since these loans are intended to be quickly repaid, there are harsh penalties if they're not repaid on time. Plus, though you may be able to get funding instantly or in a few hours, the costs are often extremely high, with fees equating to APRs of nearly 400% or more.

To the greatest extent possible, it’s best to avoid payday loans. Many who use payday loans find themselves in a cycle of borrowing that’s difficult to escape because the fees are so high. If you decide to get a payday loan, make sure to use a reputable lender with reasonable rates and terms. You can also check our payday loan list for customer reviews.

» MORE: Payday loans vs. personal loans

The cost of payday loans

Payday loans commonly carry fees ranging from 10% to 30% of the loan amount, though these fees vary by state. For instance, let’s say you get a payday loan of $300 with a fee of 15%, or $45. If you repay the loan when you get your next paycheck in two weeks, the fee is equivalent to an APR of almost 400%.

If you don’t repay the loan when it comes due in two weeks, some states might allow you to roll it into a new loan. Assuming you’re charged another 15% fee to do this, your APR is unchanged at nearly 400%, but you’d owe your lender another $45 to extend the term by two weeks.

Many lenders require you to give them a postdated check for the amount you borrowed when you get the payday loan. If you don’t have sufficient funds to cover the postdated check when your lender deposits it when the loan comes due, you might owe your bank and payday lender nonsufficient funds (NSF) fees.

On average, banks charge $34 for NSF fees, according to the Consumer Financial Protection Bureau (CFPB).

Payday loans pros and cons

People may consider getting a payday loan because it’s easy to apply, you can get cash as soon as the day you apply, even people with bad credit can get funding and the approval rate is high.

Although these seem like advantages, payday loans should generally be avoided. The APRs are often extremely high, the funds must be repaid in days or weeks and penalties for not repaying it on time can be steep. Additionally, although payday loans are not reported to credit bureaus, your credit could be negatively affected if you don’t pay your loan as agreed, it’s turned over to collections or you’re sued for the balance.

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Payday loans and the law

Many states have legal statutes specifically allowing payday lending. However, there are at least 21 states where traditional payday lending is expressly prohibited or effectively disallowed due to payday lending statutes expiring or being repealed, due to annual percentage rate (APR) caps on consumer loans or because there aren’t any licensed payday lenders in the state.

Payday loans are prohibited, heavily restricted or there aren’t any licensed lenders in Washington, D.C., and these 21 states:

• Arizona
• Arkansas
• Colorado
• Connecticut
• Georgia
• Hawaii
• Illinois
• Maryland
• Massachusetts
• Montana
• Nebraska
• New Hampshire
• New Jersey
• New Mexico
• New York
• North Carolina
• Ohio
• Pennsylvania
• South Dakota
• Vermont
• West Virginia

A key goal of APR caps and other payday lending laws is to protect consumers from usurious rates and other predatory lending practices. For example, APRs can’t exceed 33% in Maryland and 36% in Colorado. These rates are much lower than the APRs of nearly 400% or more that you might be charged for small payday loans in some other states, such as California.

If you believe you’ve been a victim of predatory lending practices, you can file a complaint with the CFPB. As a consumer, you can file reports of fraud or other illegal activity with your state's Federal Trade Commission (FTC) or attorney general’s office.

Alternatives to payday loans

If you find yourself in need of quick funding, there are many alternatives you should consider before turning to a payday loan. Many of these options, such as personal loans, payday alternative loans and paycheck advances can also get you quick funding. Plus, there are even options available for people with poor credit or no credit history, and these rates are typically much lower than what you’ll pay for a payday loan.

As you’re considering your funding options, Gates Little, president of The Southern Bank Company, noted that “even using a high-interest credit card will cost you less interest than a payday loan.” While it’s best to keep your credit utilization ratio to 30% or less, even credit card availability of as little as $500 to $1,000 can help you avoid payday loans.

Building an emergency fund can also be a way to help you avoid payday loans, even if you’re only able to initially save $1,000 or less. Little explained that having an emergency fund “you replenish over time instead of using high-interest loans or credit cards can help you when you need immediate access to cash.”

Additionally, if your funding need is related to a cash flow problem, Little suggests reaching out to your lender or service provider. “Explain the situation and ask to defer your payment,” said Little. Not only might this help you avoid having your services cut off, Little explained, but you may also avoid having non-payments negatively reflected on your credit reports.

Furthermore, “Calling your creditors can open up options like a payment plan or even debt reduction,” Little said. “So it is worthwhile to be proactive and in communication with your creditors.”

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Bottom line

Payday loans are very small loans consumers who need money fast or have bad credit may use as a funding source. While these loans can be extremely easy to get, they can be difficult to pay back because the repayment term is so short and the fees are so high.

You’ll usually need to repay the loan in full when you get your next paycheck (in two to four weeks). Since the loans are so easy to get, they often carry fees equivalent to an APR of 400% or more.

People already strapped for cash may find it difficult to repay the loan when it comes due, which can cause them to get caught in a perpetual borrowing cycle. So, before turning to this type of loan, it’s best to first exhaust all other funding options.