How Payday Loans Work

If you are in need of quick cash, you may be considering a payday loan. Here’s how they work.

If you need cash in a hurry, you might be thinking about getting a payday loan. Before getting this kind of loan, though, be sure you fully understand how payday loans work, the biggest downsides to these kinds of loans, as well as what kinds of laws apply to them.

What’s a Payday Loan?

Payday loans are loans for smaller amounts, often $500 or less. The loan generally has to be repaid in a single payment on the borrower’s next payday or when the borrower gets income from another steady source, like a pension or Social Security.

Process of Getting a Payday Loan

Depending on your state’s laws, you might be able to get a payday loan in a store, over the phone, or online. Here’s how the process of getting a payday loan works in each of these three ways:

Getting the loan in person using a postdated check. One way to get a payday loan is to visit the lender's store and give the lender a postdated check. You then get back an amount of money that's less than the face value of the check. The lender cashes the check on the loan’s due date, which generally corresponds with the date of your next paycheck.

Getting the loan in person and giving the lender access to your bank account. Another way to get a payday loan is to go to the store in person, but instead of providing a postdated check, you get cash from the lender and sign an agreement. The agreement gives the lender the right to withdraw money from your bank account—or from a prepaid card to which money like wages, is regularly added—once the loan comes due.

Getting the loan online or by phone. Payday loans are also available online or over the phone. If you’re approved for the loan, the money is typically deposited to your checking account, and your loan payment will be due around your next payday. Most lenders offer an option where your payment is automatically processed on the due date.

Qualifying for a Payday Loan

Qualifying for a payday loan is quite easy. Ordinarily you’ll have to show proof of your income, like two recent pay stubs and meet the following requirements:

  • You must be 18 years old or older.
  • You must have a bank account or prepaid card account.
  • You must have a working phone number.
  • You must provide a valid government-issued photo ID, like a driver’s license.
  • You must provide a social security number.

However, in most cases, the lender won’t consider your credit score or review your credit report.

Biggest Downsides: Astronomical Interest Rates, Treadmill of Debt

A payday loan could end up costing you a lot of money, and you might end up on the payday loan treadmill, taking out one loan after another.

Payday loans have very high APRs. A typical payday loan borrower pays more than $520 to repay a $375 loan. The annual percentage rate (APR) on even one payday loan is astronomical, ranging from 200% to 500% or more.

Payday loans can lead to a treadmill of debt. According to the Consumer Financial Protection Bureau, about 70% of people who get a payday loan end up taking out another loan within 30 days, and 20% of new payday loan borrowers take out ten or more payday loans in a row. Each time you roll over the loan, you pay more and more on the original debt.

You should think very carefully, and consider alternatives, before you get a payday loan. (Learn more in Should I Get a Payday Loan?)

Payday Lending Laws: State and Federal Laws

Certain states have laws regulating payday lending and a new federal law protecting payday loan borrowers will, in theory, go into effect in 2019.

State laws. To reduce payday lending abuses, some state laws limit the amount a lender can charge for a payday loan, limit the repayment period, and/or limit the maximum amount a borrower can get. Other states have gone as far as making payday lending illegal.

Federal law. In 2017, federal regulators established a rule that sets a nationwide set of minimum protections for consumers regarding payday loans. The new federal rule, issued by the Consumer Financial Protection Bureau (CFPB), is called the Payday Rule. Under the Payday Rule, payday lenders have to perform a “full-payment test” before making a loan to figure out whether a borrower will be able to repay the loan without rolling it over. The Payday Rule also includes a “debit attempt cutoff” for certain payday loans. After two unsuccessful attempts to debit the borrower's account, the lender can’t debit the account again unless the borrower provides a new authorization. And, the lender has to give consumers written notice before attempting to debit an account at an irregular interval or amount.

The Payday Rule went into effect on January 16, 2018, but lenders aren't required comply with most of the provisions until August 19, 2019. However, on January 16, 2018, the CFPB announced it was going to “reconsider” the Payday Rule. This announcement casts doubt on when and if the rule will actually go into effect.

Getting Help

To find out about the payday lending laws in your state, see the National Conference of State Legislatures website. To get an explanation about applicable payday loan laws, consider contacting a consumer protection lawyer.

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