What are Payday Loans?
Payday loans have a major stigma, and for good reason. We examine the practice further to get a better understanding, while offering up alternative solutions.
August 17, 2021
Payday loans may have a negative stigma attached to them, yet they’re still easily accessible in many parts of the country. So, if they’re undesirable, why are they still common? What’s involved in taking out a payday loan, and how is the interest on a payday loan calculated?
Let’s answer these and other common questions. We’ll take a closer look at what is a payday loan and why you generally want to steer clear from this source of funding.
What is a payday loan?
Payday loans — which are also known as cash advances or check loans — can generally be distinguished by their:
Repayment terms. Payday loans are short-term loans, typically issued with the due date set to coincide with the recipient’s next payday. For example, if you took out a payday loan on the 5th of the month and were set to receive your next paycheck on the 15th, your payday loan would be due for payment — including the amount you borrowed and all applicable fees — on the 15th.
Low limits. Because payday loans are meant to be paid off by the recipient’s next payday, lenders generally base the amount they offer on the recipient’s anticipated paycheck. For this reason, short-term payday loans are usually given for small amounts — typically no more than $500 at a time.
High interest rates and fees. Unlike traditional credit card interest rates, payday loans usually charge a fee per $100 borrowed (often between $10-$30 per $100 borrowed). However, as the Consumer Financial Protection Bureau explains, this can translate into astronomical interest rates. “A fee of $15 per $100 is common,” the agency states. “This equates to an annual percentage rate of almost 400% for a two-week loan.”
Because of these exorbitant fees — and because payday loans are generally offered without consideration for how the recipient’s other expenses may impact their ability to repay the loan — payday loans are typically considered to be predatory loans.
How do payday loans work?
To receive a payday loan, you’ll need to:
Be at least 18 years old
Provide valid identification
Have proof of income
If you don’t meet one or more of the above criteria, you may be denied a payday loan. Payday loans can be accessed in retail settings and online — in either case, you’ll be asked to fill out an application for consideration.
If your loan request is approved, you may receive your proceeds in cash, as a check, on a prepaid debit card or via bank transfer. Depending on your lender’s policies, you may be required to provide authorization for the lender to withdraw the amount due on your due date or to leave a post-dated check for the full amount due, to be cashed by your lender on the loan’s due date.
If you cannot repay your payday loan on your due date, you may be able to roll over your original loan into a new payday loan or request an extended payment plan. However, not all states require that payday lenders offer these options, and even those that do may allow lenders to assess additional fees for them.
The National Conference of State Legislatures maintains a helpful table of state-specific payday loan regulations that can help you understand the applicable restrictions in your state.
Calculating payday loan interest rates
Although the Truth in Lending Act requires payday lenders to disclose their finance charges, this information isn’t always clear or easily accessible. Before you sign on the dotted line, make sure you understand the full financial implications of your decision by calculating the true annual percentage rate (APR) of your loan.
So, how is the interest rate on a payday loan calculated? To start, you’ll need to know:
The total amount you plan to finance
The cost of the loan, per $100
The term of the loan, in days
For this example, let’s imagine you plan to borrow $400, that you’ll pay $20 per $100 to execute the loan, and that you’ll repay it in 14 days.
Calculate the total finance charge for taking out the loan. In this case, at a rate of $20 per $100, the total finance charge will be $80.
Divide the total finance charge by the amount you plan to borrow. Here, $80 divided by $400 is 0.2.
Take the total and multiply it by the total number of days in a year; in this case, 0.2 multiplied by 365 is 73.
Divide the answer by the length of the payday loan’s term. Here, 73 divided by 14 is 5.2143.
Finally, take that number and move the decimal point two places to the right to get your APR expressed as a percentage rate.
Completing this example, step 4’s result of 5.2143 becomes an annual percentage rate of 521.43%. Compared to typical credit card interest rates of 12% to 30% APR, payday loans represent a significantly more expensive means of accessing money.
Making smart choices when it comes to payday loans
Research by the Consumer Financial Protection Bureau has found that as many as four out of five payday loans are rolled over or renewed. This is understandable. If you’re short on cash ahead of your next payday, adding the burden of repaying a payday loan out of your next paycheck risks turning a single shortfall into an ongoing cycle that traps you in short-term debt.
Unless payday loans are absolutely the only option available to you, it’s best to avoid them from the start by looking for other options to secure the funds you need. Traditional credit cards, personal loans or programs like Tally’s Tally+ Express debt consolidation loan may be able to give you the financial breathing room you need without the risks associated with payday loans.
Learn more about how Tally may be able to help you eliminate high-interest credit card debt and late payments.