How Do Payday Loans Work?

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“Borrower beware” is the standard cautionary tale when it comes to payday loans. In some states that qualify as the Wild West of payday lending, the better advice is to run for your life.

Payday loans are the face of predatory lending and high-risk loans in America for one reason: The average annual percentage rate on a payday loan is 391% and can be higher than 600%!

The Consumer Financial Protection Bureau reported in 2022 that 12 million borrowers take out payday loans every year. Twelve states ban payday lending altogether. Many others require lenders to offer no-cost extended payment plans but it’s not in the best interest of those lenders to advertise options that mean less money for them.

The result is borrowers who are unable to pay back loans within two weeks where payday lending is legal will roll over those loans and get charged an additional payday loan fee. The CFPB study said that 80% of payday loans don’t get paid back in that two-week window, and borrowers use the rollover option so many times the accrued fees were greater than the original loan amount.

You may think a payday loan is the only solution for handling an emergency, but financial advisors and credit counselors warn that payday loans often cost more than the problem you’re trying to solve.

You can see why by comparing payday loan interest rates of 391%-600% with the average rate for alternatives like credit cards (15%-30%), debt management programs (8%-10%), personal loans (14%-35%) and online lending (10%-35%).

“Borrowing money via a payday loan only makes sense when facing an emergency – after you have exhausted all
other funding channels, including family and friends, credit cards and traditional personal loans from banks and
credit unions,” Thomas Brock, CFA, and CPA, said.

There’s been a crackdown on high interest rates – to some extent – with 18 states capping 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%. In Texas, where there are no caps, interest can go as high as 662% on $300 borrowed.

What does that mean in real numbers? It means that if you pay it back in two weeks, it will cost $370. If it takes five months, it will cost $1,001.

Just think. Five months is the average 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.

Understanding Payday Loans

Payday loans are a quick-fix solution for consumers in a financial crisis, but also are budget-busting borrowing for families and individuals.

Here is how a payday loan works:

Consumers fill out a registration form at a payday lending office or online. Government-issued identification, a recent pay stub and bank account number are the only documents needed. No credit check is necessary.

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.

Borrowing Limits with a Payday Loan

Pew Charitable Trust research on payday loans finds that borrowers in some states pay twice as much for the same loans that customers get in other states with more stringent limits.

The research showed that while the four largest payday lenders in the U.S. charge similar prices within a given state – typically at the maximum the state law allows – in states with higher or no interest rate limits those same companies up-charge their customers accordingly.

For example, in Colorado the average interest cost on a $300 loan for a two-week pay period is $16. Borrowing the same amount in Texas can cost a borrower $70.

The average percentage rate in Colorado is 129% while in states with no limits the APR can be as high as 582%. That $300 loan in Colorado will cost a borrower $172 in interest over five months. In Texas, that same loan over five months can cost $702.

As an industry fix, Pew recommends limiting payday loan payments to an affordable percentage of a borrower’s periodic income. But many payday lenders and enablers in state legislatures aren’t interested in what’s best for the borrowers.

State-Specific Payday Loan Caps

The amount a consumer can borrow on a payday loan varies by state. The median payday loan is $350 on a two-week term, according to CFPB statistics. But the caps on payday loan amounts vary greatly across the United States.

Thirty two states employ capped maximum loan amounts ranging from $300 (California and Montana) to $1,000 (Delaware, Idaho, and Illinois. Four states do not have a cap.

Some states base their limits on a person’s monthly income. In Nevada, the loan can’t exceed 25% of that number. Is that enough to protect borrowers from getting in over their heads? Not likely.

No wonder 12 states have prohibited payday loans while others have enacted laws that essentially have done away with payday lending. The 12 states where payday loans are banned: Arizona, Arkansas, Colorado, Georgia, Massachusetts, Maryland, New Jersey, New York, North Carolina, Pennsylvania, West Virginia, and Vermont.

How to Secure a Payday Loan

The No. 1 reason people take out payday loans is desperation. A consumer needs a quick fix for a financial emergency and doesn’t believe they have other options, often because of bad credit.

But that shouldn’t mean pulling into the first storefront offering payday loans and walking out with some cash. Protecting yourself requires some homework.

“Vetting a payday lender is crucial to ensure you do not fall prey to a bad actor,” Brock said. “A key step in the vetting process is to verify a payday lender’s legitimacy and compliance with state regulations, which vary significantly.

“Most states require payday loan companies to be registered or licensed and, in the name of consumer protection, have taken steps to limit accessibility to these loans.”

You can get a payday loan in person, or online depending on your state’s laws and restrictions.

Qualifying for a payday loan isn’t the strictest process. Still, you must meet certain criteria:

  • Be at least 18 years old
  • Provide valid identification
  • Have a checking account
  • Show your pay stubs

Getting a loan can happen in less than 30 minutes. Lenders often require the borrower to post-date a check for the loan amount (plus the lending fee). The lender keeps that check until the due date (usually two weeks hence.)

How Payday Loan Interest Rates Are Calculated

The average payday loan is $375. The average interest – or “finance charge” as payday lenders refer to it is 15%-20%. That puts the interest charge between $56.25 and $75 for a $375 loan.

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 credit offer. If you used a credit card instead, even at the highest credit card rate available, you’d pay less than one-tenth the amount of interest you are charged on a payday loan.

How Payday Loan Finance Charges Are Calculated

The average payday loan in 2023 was $375, according to the Pew Trusts. 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.

The CFPB estimates the typical payday loan borrower spends $520 to borrow $375, according to 2023 statistics.

The interest/finance charge typically is 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.

What Happens If You Can’t Repay Payday Loans?

If a consumer can’t meet the two-week deadline for repayment, they can ask the lender to “roll over” the loan. If the state allows it, the borrower just pays whatever fees are due, and the loan is extended. But the interest grows, as do finance charges.

Using the lowest finance charge available ($15 per $100 borrowed) on a $375 loan, 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.

What Is a Rollover Loan?

When you can’t pay back the money borrowed within two weeks, the lender will “renew” the loan typically for another two weeks. That’s a rollover loan. But better to see it as the first rumblings of a financial avalanche.

The borrower still owes the outstanding principal and the interest on that principal but now even more in finance charges. You are basically charged a fee for the delay in paying back the original loan.

Do Payday Loans Affect My Credit

Payday lenders don’t check borrowers’ credit scores before advancing a loan. Accordingly, they don’t typically report any information about payday loan borrowing to the nationwide credit reporting companies.

If there’s an upside to doing business with a non-traditional lender who charges exorbitant interest rates, it begins and ends there.

The CFPB advises that if you don’t pay your loan back and the lender turns your delinquency over to a debt collector, however, that debt collector could report the debt to a national credit reporting company. And that would affect your credit score.

There’s a second scenario where an unpaid payday loan debt could affect your credit score: a lender winning a lawsuit against you over an unpaid loan could appear on your credit report and damage your score.

Payday Loan Alternatives

Twelve million American consumers get payday loans every year, despite the ample evidence that payday loans send most borrowers deeper into debt.

There are alternatives to payday loans. Community agencies, churches and private charities are the first place to try for help. If that doesn’t work, here are more alternatives worth researching.

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. If your company doesn’t offer this, you can check out a cash advance app.

Borrow from family or friends: Borrowing money from friends or family is a fast and far less expensive way to dig yourself out of trouble. You would expect to pay a much lower interest rate and have a far more generous timeframe than two weeks to pay off a loan, but to avoid sabotaging a friendship or relationship 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: 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%.

Peer-to-Peer Lending: If you’re still having problems finding a source of money, go online and check the peer-to-peer lending sites. The interest rates could be closer 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.

» Learn More: Best Ways to Borrow Money

Payday Loans and the Military Lending Act

The Military Lending Act protects service members and their dependents against predatory lending practices in part by capping interest rates on most consumer loans at 36%.

While that cap doesn’t benefit military members paying high interest credit cards of 25-30%, it does provide a shield against payday lending practices.

The Act benefits military members in other ways including:

  • Not allowing creditors to require mandatory arbitration or demanding military members cede rights under State or Federal laws like the Servicemembers Civil Relief Act.
  • Protecting borrowers against prepayment penalties.
  • Not allowing lenders to require an “allotment” – an automatic withdrawal from a borrower’s paycheck to pay back the loan.

Are Payday Loans Legal?

Payday loans, where legal, are subject to regulation. But that regulation is, fittingly, all over the map.

Many state legislatures have banned payday lending or enacted strict regulations (36% caps for one) that substantially curb predatory lending and, hence, cause payday lenders to leave a particular state and do business elsewhere.

The Consumer Federation of America (CFA) provides a detailed look at how payday loans vary state to state and warns against taking out payday loans where state legislatures have deregulated small loans, exempted payday loans from usury laws or “enacted legislation to authorize loans based on holding the borrower’s check or electronic payment from a bank account.”

The CFA counts 21 states and the District of Columbia as “prohibiting extremely high cost payday lending.” While 29 states still allow high-cost payday lending, according to the CFA’s definition, a trend toward better policing of payday lending seems to be afoot. Five states – Nebraska, Hawaii, Illinois, New Mexico, and Minnesota – have taken legislative steps to cap rates at 36% just since 2020.

Empowering Your Financial Decision-Making

Payday lenders thrive in desperate economic situations, taking specific advantage of borrowers with limited credit options.

The CFPB estimates that 80% of payday loans get rolled over and 20% end up in default. The cost to those borrowers often includes bank fees for insufficient funds along the way.

Thirty–two states allow brick and mortar payday lending stores, a neon enticement that often proves too difficult to resist for people who would be far better served researching alternatives.

“Many lenders prey on naive consumers,” Brock said. “Incurring this type of debt can easily pull you into a downward spiral of financial ruin.”

If you’re struggling to make ends meet, the best place to start getting your finances under control is nonprofit credit counseling. Credit counseling can not only help you devise a budget and a debt management plan, but credit counselors can also steer you to places in your local area that can assist you in myriad ways.

When it comes to managing your money, desperate times call for the smartest measures.

About The Author

Tom Jackson

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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