How Do Payday Loans Work?

Payday loans are a fast, easy, and costly way to get money. Here’s how they work.

If you need to get your hands on some cash, you might be thinking about getting a payday loan. While this kind of loan might seem like a great way to get money quickly, you should know that these loans—in states that allow them—have significant downsides, including punishing interest rates and short repayment timeframes.

Before you apply for a payday loan, you should fully understand how they work and seriously consider the costs involved, as well as the risks. You might change your mind about getting one.

What Is a Payday Loan?

A payday loan is a short-term loan from a payday loan company or online vendor—not a bank—that usually becomes due on your next payday or the next time you get income from some other regular source, like Social Security. Typically, payday loans are relatively small, around $500 or less. State law often limits the maximum loan amount.

How to Get a Payday Loan

Depending on your state’s laws, you might be able to get a payday loan in person (by using a postdated check or giving the lender access to your bank account), over the phone, or online. Here’s how the payday loan process works in each of these three ways:

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.

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.

Online or by Phone

Payday loans are also available online or over the phone. If you’re approved for the loan, the money is normally 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 Payday Loans: No Credit Check Required

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 other qualifications, such as having a bank account or prepaid card account, a working phone number, a valid government-issued photo ID (like a driver’s license), and providing a Social Security number or Individual Taxpayer Identification number. But in most cases, the lender won’t do a credit check to look at your credit score or review your credit report.

Downsides to Payday Loans

A payday loan could end up costing you a lot of money, especially if you take out one loan after another.

Treadmill of Debt

Even if you owe a payday loan, you can get another. 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. But this practice can lead to a treadmill of debt that will end up costing you a lot of money. Each time you get another loan, you pay more and more.

Example of the Payday Loan Treadmill of Debt

Suppose you borrow $400 from a payday lender today. The lender charges a fee of $15 per $100 borrowed, so you'll have to pay the lender $460 in a couple of weeks. Unfortunately, when the due date comes around, you can’t afford to repay the payday loan. So, because your state doesn’t ban or limit loan renewals, you “roll over” (extend) the loan and push the due date out by another couple of weeks. To do this, you have to pay another $60 fee. When the loan comes due again, you pay the lender the $520 you owe. You've now spent $120 to borrow $400.

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. Continuing with the example above, the APR on a two-week loan with a $15 fee per $100 borrowed is around 400%.

Payday Loan Laws

Some states have laws regulating payday lending and, starting in late-2020, federal law further regulates payday lenders.

State Laws

State law sometimes limits the amount a lender can charge for a payday loan, limits the repayment period, or limits the maximum amount a borrower can get. Some states have gone as far as making payday lending illegal.

Federal Law

Federal regulators have established a rule that sets a nationwide set of minimum protections for consumers regarding payday loans. The federal law, which goes into effect on November 19, 2020, is called the "Payday Lending Rule."

Under the Payday Lending Rule, among other things, 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 having to roll it over. (12 C.F.R. § 1041.5).

Alternatives to Taking Out a Payday Loan

If you're having financial troubles, consider other options instead of taking out a payday loan, like:

  • getting an advance or emergency loan from an employer, nonprofit organization, or community group
  • if you have an account at a bank or credit union, you might be able to get a less expensive loan, especially if you have a stable credit history
  • getting a cash advance from your credit card (while using your credit card to get a cash advance is also a pricey option, it’s likely cheaper than taking out a payday loan), or
  • negotiating with a creditor or debt collector about a debt or bill you owe.

Learn More

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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