How Do Payday Loans Work?
If you can’t repay the loans – and the Consumer Financial Protection Bureau says 80% of payday loans don’t get paid back in two weeks – then the interest rate soars and the amount you owe rises, making it almost impossible to pay it off.
You may think a payday loan is the only solution for handling an emergency bill, or even pay off another debt, but the truth is, a payday loan will end up costing you more than the problem you’re trying to solve. It’ll add up to more than any late fee or bounced check fee you’re trying to avoid.
Compare payday loan interest rates of 391%-600% with the average rate for alternative choices like credit cards (15%-30%); debt management programs (8%-10%); personal loans (14%-35%) and online lending (10%-35%). Should payday loans even be considered an option?
Some states have cracked down on high interest rates – to some extent. Payday loans are banned in 12 states, and 18 states cap interest at 36% on a $300 loan. For $500 loans, 45 states and Washington D.C. have caps, but some are pretty high. The median is 38.5%. But some states don’t have caps at all. In Texas, interest can go as high as 662% on $300 borrowed. What does that mean in real numbers? It means that if it you pay it back in two weeks, it will cost $370. If it takes five months, it will cost $1,001.
By the way, five months is the average amount of time it takes to pay back a $300 payday loan, according to the Pew Charitable Trusts.
So before you grab at that quick, very expensive money, understand what payday loans entail.
Payday Loan Changes Retracted
The Consumer Financial Protection Bureau introduced a series of regulation changes in 2017 to help protect borrowers, including forcing payday lenders – what the bureau calls “small dollar lenders” — to determine if the borrower could afford to take on a loan with a 391% interest rate, called the Mandatory Underwriting Rule.
But the Trump administration rejected the argument that consumers needed protection, and the CPFB revoked the underwriting rule in 2020.
Other safeguards relating to how loans are paid back remain, including:
- A lender can’t take the borrower’s car title as collateral for a loan, unlike title loans.
- A lender can’t make a loan to a consumer who already has a short-term loan.
- The lender is restricted to extending loans to borrowers who have paid at least one-third of the principal owed on each extension.
- Lenders are required to disclose the Principal Payoff Option to all borrowers.
- Lenders can’t repeatedly try to withdraw money from the borrower’s bank account if the money isn’t there.
Congress and states are also working on strengthening protections, including a move to bring the 36% interest cap to all states. In 2021 alone, Illinois, Indiana, Minnesota, Tennessee and Virginia all clamped down on payday loan interest rates.
How Do Payday Loans Work?
Payday loans are a quick-fix solution for consumers in a financial crisis, but also are budget busting expenses for families and individuals.
Here is how a payday loan works:
Consumers fill out a registration form at a payday lending office or online. Identification, a recent pay stub and bank account number are the only documents needed.
Loan amounts vary from $50 to $1,000, depending on the law in your state. If approved, you receive cash on the spot, or it’s deposited in your bank account within one or two days.
Full payment is due on the borrower’s next payday, which typically is two weeks.
Borrowers either post-date a personal check to coincide with their next paycheck or allow the lender to automatically withdraw the money from their account.
Payday lenders usually charge interest of $15-$20 for every $100 borrowed. Calculated on an annual percentage rate basis (APR) – the same as is used for credit cards, mortgages, auto loans, etc. – that APR ranges from 391% to more than 521% for payday loans.
What Happens If You Can’t Repay Payday Loans?
If a consumer can’t repay the loan by the two-week deadline, they can ask the lender to “roll over” the loan. If the borrower’s state allows it, the borrower just pays whatever fees are due, and the loan is extended. But the interest grows, as do finance charges.
For example, the average payday loan is $375. Using the lowest finance charge available ($15 per $100 borrowed), the customer owes a finance charge of $56.25 for a total loan amount of $431.25.
If they chose to “roll over” the payday loan, the new amount would be $495.94. That is the amount borrowed $431.25, plus finance charge of $64.69 = $495.94.
That is how a $375 loan becomes nearly $500 in one month.
How Payday Loan Finance Charges Are Calculated
The average payday loan in 2021 was $375. The average interest – or “finance charge” as payday lenders refer to it – for a $375 loan would be between $56.25 and $75, depending on the terms.
That interest/finance charge typically is somewhere between 15% and 20%, depending on the lender, but could be higher. State laws regulate the maximum interest a payday lender may charge.
The amount of interest paid is calculated by multiplying the amount borrowed by the interest charge.
From a mathematical standpoint, it looks like this for a 15% loan: 375 x .15 = 56.25. If you accepted terms of $20 per $100 borrowed (20%), it would look like this: 375 x .20 = 75.
That means you must pay $56.25 to borrow $375. That is an interest rate of 391% APR. If you pay $20 per $100 borrowed, you pay a finance charge of $75 and an interest rate of 521% APR.
How Payday Loan Interest Rates Are Calculated
The annual percentage interest rate (APR) for payday loans is calculated by dividing the amount of interest paid by the amount borrowed; multiplying that by 365; divide that number by the length of repayment term; and multiply by 100.
In mathematical terms, the APR calculations on a $375 loan look like this:
56.25 ÷ 375 = .15 x 365 = 54.75 ÷ 14 = 3.91 x 100 = 391%.
For the $20 per $100 borrowed (or 20%) on a $375 loan, it looks like this: 75 ÷ 375 = .2 x 365 = 73 ÷ 14 = 5.21 x 100 = 521%.
Again, the APR is astronomically higher than any other lending offered. If you used a credit card instead, even at the highest credit card rate available, you are paying less than one-tenth the amount of interest that you would on a payday loan.
Payday Loan Alternatives
Surveys suggest that 12 million American consumers get payday loans every year, despite the ample evidence that they send most borrowers into deeper debt.
There are other ways to find debt relief without resorting to payday loans. Community agencies, churches and private charities are the easiest places to try.
Paycheck advance: Many companies offer employees a chance to get money they earned before their paycheck is due. For example, if an employee has worked seven days and the next scheduled paycheck isn’t due for another five days, the company can pay the employee for the seven days. It is not a loan. It will be deducted when the next payday arrives.
Borrow from family or friends: Borrowing money from friends or family is a fast and often the least expensive way to dig yourself out of trouble. You would expect to pay much lower interest rate and have far more generous timeframe than two weeks to pay off a loan, but make sure this is a business deal that makes both sides happy. Draw up an agreement that makes the terms of the loan clear. And stick to it.
Credit Counseling: Nonprofit credit counseling agencies like InCharge Debt Solutions offer free advice on how to set up an affordable monthly budget and chip away at debt. InCharge credit counselors can direct you to places in your area that offer assistance with food, clothing, rent and utility bills to help people get through a financial crisis.
Debt management plans: Nonprofit credit counseling agencies like InCharge also offer a service, at a monthly fee, to reduce credit card debt through debt management plans. The creditor offers a lower interest rate to the agency, and you can agree whether to accept it. The agency pays the creditors, and you make one monthly payment to the agency, which frees up money so you can pay your bills and reduce the debt. The plan pays off the debt in 3-5 years.
Debt Settlement: If trying to keep pace with unsecured debt (credit cards, hospital bills, personal loans) is the reason you’re always out of money, you could choose debt settlement as a debt-relief option. Debt settlement means negotiating to pay less than what you owe, but it comes with a major stain on your credit report and heavy price on your credit score.
Local charities and churches: If you have hit a bump in the road, there are a surprising number of charities and churches willing to lend assistance at no cost. Organizations like United Way, Salvation Army and church-sponsored ministries like the St. Vincent de Paul Society often step in when all you need is a few hundred dollars to get through a tough stretch.
Community banks and credit unions: The regulations allow local banks and credit unions to make smaller loans on easier repayment terms than the large regional or national banks do. Call or visit to compare interest rates, which could be as low as 10%-12% as compared to 400%-500% rates on payday loans.
Peer-to-Peer Lending: If you’re still having problem finding a source of money, go online and check the peer-to-peer lending sites. The interest rates could be close to 35% than the 6% rate those with great credit receive, but 35% is still a lot better than the 391% from a payday lender.
Payday Loans Target Military, Low-Income
Payday lenders prey on people in desperate economic situations, meaning low-income, minority families, members of the military and anyone else who has limited credit options.
The CFPB estimates that 80% of payday loans get rolled over and 20% end up in default, which goes on your credit report for seven years and all but eliminates you from getting loans in the near future.
Another penalty consumers often incur from payday loans is nonsufficient funds (bounced-check) charges from you bank. If you don’t have the money in your account when the payday lender tries to cash the post-dated check you wrote or takes the money out by direct deposit, most banks charge a $25-$35 penalty.
Default also opens you up to harassment from debt collection agencies, who either buy the loan from the payday lender or are hired to collect it. Either way, you can expect the phone to ring until you pay.
There also is long-term damage to your credit score. Though some payday lenders don’t report directly to the three major credit reporting bureaus in the United States, most report to the minor agencies. If the debt goes to a collection agency, that agency almost always reports non-payment to the major credit bureaus, which ruins your credit.
About The Author
Tom Jackson focuses on writing about debt solutions for consumers struggling to make ends meet. His background includes time as a columnist for newspapers in Washington D.C., Tampa and Sacramento, Calif., where he reported and commented on everything from city and state budgets to the marketing of local businesses and how the business of professional sports impacts a city. Along the way, he has racked up state and national awards for writing, editing and design. Tom’s blogging on the 2016 election won a pair of top honors from the Florida Press Club. A University of Florida alumnus, St. Louis Cardinals fan and eager-if-haphazard golfer, Tom splits time between Tampa and Cashiers, N.C., with his wife of 40 years, college-age son, and Spencer, a yappy Shetland sheepdog.
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