Westend61/Getty ImagesPayday loans are unsecured personal loans that are usually repaid on your next payday. They can be a tempting option to get the cash you need fast, but more often than not, their hidden fees and high rates can leave you stuck in debt.
You will usually pay between 150 and 650 percent (or more) interest, depending on your state of residence. Moreover, the probability of default on payday loans is rather high and you’d better use another source of finance to overcome a financial difficulty.
What are payday loans
Payday loans are unsecured personal loans that you usually have to pay off before your next payday (or within two weeks) and usually total $500 or less. Since these loans are often an option of last resort for borrowers with poor credit, payday loans tend to carry significantly higher interest rates than traditional personal loans and can come with a plethora of hidden fees. For this reason, payday loans are often criticized for being predatory, especially for borrowers with bad credit.
“The best way to identify a payday loan is whenever you borrow money and pay the entire amount back at once, normally your payday,” says Jeff Zhou, co-founder and CEO of Fig Tech. , which offers alternative payday loans. Also, most payday lenders do not perform credit checks; If the lender is not interested in your credit history, it could be a sign that you are dealing with a payday lender.
How payday loans work
Payday loans can usually be obtained at a physical store or by applying online. They are regulated at the federal and state level. However several states have laws that limit the fees or interest rates that payday lenders can charge, and others have banned payday loans altogether.
To determine your rate and terms, the payday lender may request a credit check to see your credit score, although this is less common with a payday loan. The lender will also usually require proof of income and your payment date.
However, your credit score is not as important a factor with payday loans, as the lender has the power to withdraw their payment from your bank account when you receive your next paycheck. This is how payday lenders minimize their risk. They may also base your loan principal amount on a percentage of your expected income.
You can repay a payday loan in several ways. You could give the lender a post-dated check that they can deposit on the day of your next payday. Alternatively, you can authorize the lender to withdraw the funds from your bank account once you are paid by your employer or receive benefits such as social security income or a pension.
Fees and other costs
Payday lenders generally do not charge a traditional interest rate on their loans. Instead, they calculate borrowing costs and add them to the balance you owe. As an example, suppose a payday lender charges $10 for every $100 borrowed. This means you would owe $50 in fees for a $500 loan, and the $550 would be due on your next payday.
If you can’t afford the payment on your next payday, that’s when a lender may offer you a “rollover.” A rollover allows you to pay only the initial loan fee until your next paycheck, but you will still be responsible for the original loan balance plus the fee for the rollover amount. Since many payday borrowers end up carrying their balance because they can’t cover the full amount when due, these fees can add up quickly. It is therefore difficult to get out of the debt cycle of payday loans.
Payday loans vs personal loans
A payday loan and a personal loan have some similarities. Both are unsecured loans, meaning that unlike a mortgage or car loan, they are not secured by collateral. However, you will want to be aware of a few important differences.
Personal loans generally have terms of at least one year and up to several years. A payday loan has a shorter term. It is common for payday loans to be repaid within a few weeks. Usually, full payment – including interest and fees – will be due on your next payday.
A payday loan is usually for a lower amount, usually less than $500. Personal loan borrowers are generally looking for a lot more money. As of the fourth first quarter of 2021, the average balance of a new personal loan was $7,104.
Personal loans are usually paid online monthly by direct deposit from a bank account. With a payday loan, if your check is NSF or you can’t pay the full balance on the required payday, you may have to defer the loan to the next payday, resulting in more fees.
There are many types of personal loans, but most will have much lower interest rates than payday loans. Your interest rate will depend on the lender, the amount you borrow and your credit score.
Payday loans when you have bad credit
Many payday lenders don’t rely on a credit check at all. They understand that most borrowers looking for payday loans usually don’t have the best credit. Instead, lenders compensate for the increased credit risk by charging higher interest rates and additional fees.
A payday loan will not negatively affect your credit if your payday lender does not require a rigorous credit check and you can repay the full amount on the required date. If your lender requires a rigorous credit check, you may notice your credit score drop a few points.
However, if your check is NSF or you cannot pay the full balance on the required payday, the amount could be sent to a collection agency, negatively impacting your credit.
The risks of a personal loan
Although payday loans are convenient for getting quick cash, they are not without risk.
High borrowing costs
Due to high interest rates and hidden fees, payday loans can potentially derail your financial health and credit score. “Payday loans charge a high interest rate, but the biggest risk with payday loans is the fine print,” Zhou said.
The fine print can include change fees, mandatory subscription fees, or prepayment fees, which can quickly add up. To illustrate, the average consumer pays $520 in fees on a two-week payday loan for $375.
“The biggest danger with payday loans is when they turn from a short-term palliative into a long-term drain on your finances,” Zhou says. Unfortunately, only 14% of payday loan borrowers cannot afford to repay the loan.
Excessive turnover costs
If you do not intend to repay your payday loan in full by the requested date, you will need to roll over your loan, which means you will be responsible for the principal balance, additional fees and accrued interest. This is a vicious cycle that could lead you to high interest rate debt.
Alternatives to payday loans
You might not be able to get a traditional bank loan to meet your quick cash needs, but some of these methods for stretching your finances until the next payday might work better than a payday loan.