What is a payday loan and how does it work?

A payday loan is a type of short-term, high-interest personal loan that becomes due when you get your next paycheck. Payday loans may look attractive in a cash crunch, especially for people with low credit scores. But the fees and interest are exorbitant, leading many borrowers to get trapped in a debt cycle as they take out one loan after another.

In this article, we will explain how payday loans work and why they are more risky than other forms of consumer loans. We’ll cover the true cost of payday loans in terms of interest rates and financing fees, as well as what happens when you can’t pay off the loan. Finally, we’ll explore some alternatives if you need to borrow money before the next payday.

Ka is the loan paid per day?

A payday loan is a small dollar loan, often $500 or less, and usually due within two to four weeks. The due date often coincides with the borrower’s next payday or when they receive another source of income, such as Social Security, a disability check, or a pension. Payday loans are sometimes referred to as cash advance loans or prepaid loans. Payday loans are a type of unsecured loan because they do not require collateral.

Although payday loans are often advertised as a resource for borrowers facing an emergency or unforeseen one-time expense, this is not how most borrowers use these high-cost loans. A study by The Pew Charitable Trusts found that 69% of borrowers used payday loans for regular bills and recurring expenses.

Payday loan services are available online and through storefront payday lenders. The rules for payday loans depend on your state’s laws. Many countries set interest rates, the maximum loan amount, or the term of the loan. A handful of states ban payday loans entirely.

But in recent years, many states have cracked down on high-interest payday loans. Not surprisingly, payday lenders are fleeing states that have imposed interest ceilings. The Pew Charitable Trust reports that payday lenders operate in 44 states as of 2004; By 2022, that number had fallen to 32 states.

How does a payday loan work?

Most payday lenders do not require a credit check to borrow money. They also don’t take into account your expenses, debts, or ability to repay the loan. Payday lenders also won’t report payments to credit bureaus, so the loan won’t show up on your credit report.

Payday loan borrowers usually need to provide proof of identity, proof of income, and bank account information. The payday lender will also require the borrower to do one of the following:

  1. Submit a personal post-dated check in conjunction with the next pay date.
  2. An ACH (Automated Clearinghouse) transfer authorization that allows a lender to withdraw funds electronically from your bank account or credit union account.

Once the loan is approved, you may receive the money in the form of cash, check, prepaid debit card, or electronic deposit.

The due date and repayment terms of the loan will be included in the loan agreement. Many payday loans are due at once.

However, some payday loan lenders also allow the borrowed money to be repaid in instalments. Depending on state laws, the borrower may be able to roll over or renew the loan. The latter option is especially dangerous for borrowers, because they risk getting trapped in the debt cycle, which we will explain shortly.

Payday loan costs

Payday loan costs range from $10 to $30 per $100 borrowed in states that do not have interest rate limits, according to the Consumer Financial Protection Bureau. The $15 fee for every $100 borrowed is fairly typical.

The $15 fee on a $100 loan might not seem like much. But on a two-week loan, that adds up to an annual percentage rate (APR) of nearly 400%.

Payday loans are one of the most expensive sources of consumer credit. By comparison, the average credit card APR was 16.17% as of February 2022. For a 24-month personal loan, the average APR was 9.41%, according to the Federal Reserve.

Payday loan risks

The real risk occurs when you do not have the money to pay off the loan. Remember: the lender has access to the borrower’s bank account or a pre-dated check.

When you don’t have the funds to cover the repayment, you may incur huge overdraft fees from your bank. If the loan causes other transactions to bounce, the loan may result in multiple penalties.

Payday loan example

Amy can pay her monthly expenses, but she pretty much lives from paycheck to paycheck. After that, her rent increased by $150 and the same month her child’s daycare bill went up by $150. This means that Amy needs to get $300 quickly. So you went to a storefront payday lender and applied for a $300 loan this month while figuring out how to tackle your monthly deficit.

To borrow $300, Amy has to pay a $45 financing fee. This doesn’t seem like much. But the loan is due within 14 days, on my mom’s next payday. This means that Amy pays an APR of close to 400%.

But when the loan comes due, Amy doesn’t have $345. And the money she borrowed went into her high rent and daycare expenses. So you pay a $45 fee to renew the loan. She has now spent $390 on her $300 loan.

If Amy is an average payday loan borrower, she will continue this cycle for five months before the loan is repaid. Assuming she extends the loan every two weeks until 22 weeks (about five months) after she gets the initial loan, she’ll pay the $495 fee. That’s a total of $795 to pay off a $300 loan.

Unfortunately, chances are high that Amy will take out more payday loans. According to the Consumer Financial Protection Bureau, approximately 70% of payday loan borrowers obtain a second payday loan within a month. Nearly one in five borrowers will have 10 or more payday loans.

What if you can’t afford to pay off a payday loan?

If you can’t pay off your payday loan, you can expect debt collectors to start chasing you. While the collection agency can sue you and possibly win a judgment on your salary, you won’t be jailed for that debt, no matter what any collector tells you. (In fact, it is illegal for debt collectors to falsely tell you that you will be arrested for debt.)

While defaulting on a payday loan can have serious consequences, you still want to prioritize your basic needs over your debt. Prioritize your rent, food, medication, and car payments if you need your car for work. Consider these options for payday loan relief.

Revoke ACH . authorization

If you give a payday lender permission to withdraw funds electronically from your account, you can contact your bank or credit union and tell them that the lender no longer has permission to debit your account. This does not change the amount you owe, of course. You can expect your payday lender to continue collection efforts. Many financial institutions will also charge you a fee. But at the very least, you can prevent the lender from taking the money you need for necessities, such as rent or food.

Note that when applying for payday loans online, it can often be difficult to know if you are applying with an actual lender or a prime generator who will be sending your information to lenders. As a result, many payday borrowers don’t know who they actually owe.

Ask about a payment plan

Some states require lenders to offer a payment plan to borrowers without charging additional fees. In other states, lenders must allow distressed borrowers to enter into a repayment plan, but they are allowed to pay additional fees.

Regardless of your state’s law, it is often in the lender’s best interest to work with you. If you can pay a lump sum less than the balance, show it. Another option is to tell the lender that you are so overwhelmed with bills that you are considering bankruptcy. Many lenders are willing to compromise in this situation, because they know they will likely never get anything in bankruptcy court.

Get credit advice

If you are overwhelmed by payday loans or any other type of debt, credit counseling is a good option. Find a nonprofit agency through the American Financial Counseling Association or the National Corporation for Credit Counseling (NFCC). A credit counselor can help you decide if a debt consolidation loan or debt management plan is possible. They can also discuss whether you need to consider bankruptcy.

Ask friends or family

If you’re in trouble, consider asking a friend or family member if they can help, either by lending you money or giving you cash directly. Just make sure you are honest about your ability to return the favor to them.

Do extra work

If you can’t afford a payday loan or payday loans are your only option to pay your regular bills, making more money may be the only solution. Consider doing a side business or finding other options to make money fast.

Payday loan alternatives

If you haven’t taken out a payday loan yet, you have other options. Here are some payday loan alternatives to consider first:

  • Alternative Payday Loan (PAL): Some low-income credit unions offer small loans called alternative payday loans that typically range from $200 to $2,000. Interest rates are capped at 28% with no rollover allowed. You will need to be a member of a credit union to qualify.
  • Credit Card or Cash Advance: Many people turn to payday loans because they do not have access to traditional credit. However, if you have a credit card, it will almost certainly be cheaper to charge your card or get a cash advance than a payday loan if you live in a state with no interest rate limits.
  • Bad credit personal loans: Even if you have a low credit score, you may qualify for a bad credit personal loan at a lower interest rate than a payday loan.
  • Military service relief organizations. Each military service has its own relief organization that provides grants and interest-free loans to service members who are facing financial needs. These include Army Emergency Relief, Coast Guard Mutual Aid, Air Force Aid Society, and Marine Corps and Marine Corps Relief Society. Application rules vary by organization.

This article was originally published by The Penny Hoarder.

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