How Payday Loans Work
A payday loan is essentially an advance against your next paycheck. You give the payday lender your pay stub as proof of income and tell them how much you want to borrow. They give you a loan for that amount, which you’re expected to repay when you receive your paycheck, along with the payday lender’s fee.
The repayment period is based on how frequently you get paid, i.e. weekly, biweekly or monthly. In addition to proof of employment and a pay stub, you’ll also need a bank statement or your bank account information to apply. Payday loans are typically deposited right into your bank account once you’re approved, so you get instant access to the money.
Depending on how the payday lender processes loans, you may have to write a post-dated check for the amount of the loan, plus any fees. Some states require the check to be dated for the day the borrower receives the money. In this case, you may have to sign a contract stating the check will be held by the lender until the agreed date of repayment.
On the date the loan comes due, you’re obligated to repay the loan, in addition to any fees the payday lender charges. If you can’t repay the loan in full, you could ask the payday lender to extend the loan or roll it into a new loan, which usually means paying another fee.
If you default on a payday loan, the potential consequences are similar to defaulting on a credit card or another unsecured debt. Failure to repay can result in the lender threatening criminal prosecution or check fraud. Not to mention, you could suffer credit score damage if the debt is sent to a collection agency.
The Downside of Easy Money: Why Payday Loans Are Dangerous
Payday loans are convenient but that convenience comes at a cost. Finance charges can range from 15 to 30 percent of the amount being borrowed, which can easily make the effective annual percentage rate on the loan in the triple-digit range.
Even if you only have the loan for a few weeks, you’re likely to pay much more in interest with a payday loan than you would for a personal loan or even a credit card cash advance. Payday loans are often problematic for the people who use them because they tend to be favored by borrowers who may not have cash or other financing options readily available.
One of the biggest pitfalls that can happen with payday loans is when a borrower falls into a cycle of repeatedly extending their loan. They find themselves unable to repay the loan on payday, so they extend the loan for another pay period. They continue spending borrowed money and in the meantime, the fees continue piling up. It’s a vicious cycle and it’s one that can continue indefinitely since there is no limit on how many times a person can get this type of loan.
Payday Loan Alternatives
The best thing you can do to avoid having to rely on payday loans is to create a budget for covering your expenses. Cut out as many unnecessary expenses as possible and focus on adding money into an emergency savings fund that you can tap when cash is short. Even the loose change found around the house can be put into savings and grow with interest over time.
Building savings takes time, however, and if an unexpected expense pops up there are other ways to handle it, beyond payday loans. For example, you may be able to cut out the middleman by simply asking your employer for an advance against your paycheck. Your employer may offer this in emergency situations, without charging the fees associated with payday loans. But, it’s not something you want to make a habit of doing.
You could also consider a pawn shop loan. If you have jewelry, tools, electronics or other items of value, you can use that as collateral for a short-term pawn shop loan. You get cash for your item and you can still come back and repay the loan and get your item back, within a set time frame. The downside is that if you don’t repay the loan, the pawn shop keeps your collateral. But, this is often a better alternative than getting an unsecured payday loan and being hit with exorbitant fees that lead to a dangerous debt spiral.
While not ideal, credit card advances can also be an alternative to a payday loan. Ideally, you’d have an emergency fund set up to cover a financial crisis, but a credit card will work in a pinch and instead of paying 300 percent APR on a payday loan you may a 25-29 percent APR on the credit card instead.
Finally, asking friends or family for a loan to help get through a hard time is another possibility. Most people have relatives or friends who will loan them the money needed to help with unforeseen expenses or emergencies. Little to no interest is usually added to these loans and arrangements can sometimes be made to pay the loan back in installments over time.
Just remember to be clear with the person you’re borrowing from about how and when the loan will be repaid. Borrowing money from friends or family members can ruin relationships if not handled appropriately so make sure to set realistic expectations at the start.