How Payday Loans Work and Why You Should Avoid Them

For someone with no credit or bad credit scores, payday loans can be a stopgap between a bill being due and an approaching payday.

But if not paid off immediately, these short-term, emergency loans can turn into what the Consumer Financial Protection Bureau, or CFPB, calls a “long-term, expensive debt burden” and trap consumers in a cycle of debt “that cause them to be living their lives off money borrowed at huge interest rates.”

About 12 million households borrow money with payday loans, with lenders collecting about $7 billion annually in fees from the more than 18,200 payday storefronts in the United States, according to the CFPB.

The median income of payday borrowers is $22,476 and nearly one in four receive some form of public assistance or other benefits as a source of income.

Expensive loans

The cost of payday loans looks low when looked at by itself — ranging from $10 to $20 per $100 borrowed, according to a CFPB whitepaper on payday loans and deposit advances. But when looked at as an annual percentage rate of interest paid, it’s a high fee for someone who uses them again and again. A $15 fee per $100 loan equates to an APR of 391% on a typical 14-day loan.

“The people who get into trouble with these loans, they become perpetual loans. They can never get ahead,” says Reggie Britt, CEO of Kwik-loan.com, which sells software to short-term lenders, though not payday lenders.

The median payday loan is for 14 days, the CFPB found. Nearly half of payday borrowers have more than 10 loans per year, and 14% took out 20 or more loans per year, the agency found in its study. The borrowers are indebted a median of 55% (199 days) of the year, and new loans are most frequently taken on the same day a previous loan is closed, or shortly thereafter.

How payday loans work

Payday loans are popular because they’re given quickly to people who often don’t qualify for other types of credit, and the money can be used to avoid overdrawing a deposit account or paying a bill late.

Being eligible for a payday loan only requires identification, proof of income (such as a paystub), and a checking account. A utility bill may be needed to prove where the borrower lives. No collateral is needed, and no credit check or consideration of other financial obligations is done.

A borrower’s ability to repay isn’t considered, with the payday lender requiring that it’s first in line when the borrower is paid from their job. This is done with a personal check or authorization to debit the customer’s checking account for repayment if the loan isn’t fully repaid on time. Other bills, such as rent and groceries, may have to wait to be paid so that the payday lender is paid first when income is deposited to the borrower’s checking account.

For the typical loan of $350, the median fee of $15 per $100 requires the borrower to come up with more than $400 in two weeks, equal to an APR of 391%, according to the CFPB.

‘Biggest mistake of our lives’

When moving to a new apartment, Randy and Brandy Miller of Elko, Nev., were told a few weeks before moving that they had to pay a higher deposit because of their credit problems. They took out a payday loan, Brandy Miller says, assuming things would get better for them. Instead, things got worse and the loan turned out to be the “biggest mistake of our lives,” she says.

[pull_quote align=”left”]”What we learned from that experience is that no matter how desperate the situation you’re in, a payday loan is not the answer,” says Brandy Miller. “It may seem like it at the time, but you’re borrowing on the assumption that your life is going to improve, and that’s something you can’t guarantee.”[/pull_quote]Her husband lost his job a month after they moved, their car broke down and they were stuck “paying this huge payday loan every paycheck which was essentially making it impossible for us to really get out of the situation,” she says.

It took them six months and financial help from a friend before they could pay off the loan.

“What we learned from that experience is that no matter how desperate the situation you’re in, a payday loan is not the answer,” Brandy Miller wrote in an email. “It may seem like it at the time, but you’re borrowing on the assumption that your life is going to improve, and that’s something you can’t guarantee. If you can’t forecast the weather with any accuracy five minutes from now, how do you expect to predict what’s going to happen in two weeks or a month from now?”

How to avoid payday loans

Being in a cycle of debt can seem impossible to get out of, but there are ways for people with little or no credit to start rebuilding their credit. Payday loans don’t affect a credit score, so getting another type of loan that does improve a credit score with timely payments can be one way to improving credit.

If possible, don’t get another payday loan immediately after paying one off, Britt says.

“That’s how they get stuck,” he says of borrowers. “They get the money to get out of one problem and they just never catch up.”

Alternative programs include short-term lenders where monthly payments are required, not all at one time like payday loans, he says. Short-term loans are still high risks for lenders, and carry 50-60% APRs.

Borrowers usually have a better chance of getting out of debt if they’re making installment payments than if they’re required to make one payment, Britt says.

The CFPB continues studying payday loans and if consumers are being protected. It recently came up with guidelines to protect members of the military who get payday loans, which we’ll cover in a blog post next week.