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What Is a Payday Loan? How Do They Work?

What Is a Payday Loan? How Do They Work?
Sarah Li Cain
Sarah Li CainUpdated December 20, 2021
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
If you need cash fast, getting a payday loan can seem like a sign of relief. Unfortunately, these loans could get you into financial trouble due to their short repayment terms and high fees. Sure, it might feel like a good way to get small amounts of cash before your next paycheck, but you could end up rolling over fees and fall further into debt. Before going this route, keep reading to learn what is a payday loan, how much it costs and whether there are other alternatives worth seeking out.

Payday Loan Definition

Payday loans are typically short-term loans featuring high costs. These types of loans are generally for amounts around $500 or less and will be due when your next payday arrives.Also called cash advance or check advance loans, the principal amount you can borrow is usually part of your paycheck. Different states have varying regulations around payday loans, which you can usually find online or at brick-and-mortar locations. 

How Do Payday Loans Work?

Payday loans are meant to help you financially until your next paycheck arrives. To get a payday loan, lenders usually won’t look at factors typical of other types of loans such as your credit history, income or other factors demonstrating your ability to pay back the loan.All you need to do is to show up (usually with a form of ID) and provide payment information. Some lenders require their borrowers to write a postdated check for the full loan amount plus fee, or authorize them to debit your checking account electronically. Once that’s complete, the lender usually gives you cash, a check, a prepaid debit card or funds through electronic bank transfer. 

Principal Amount

The amount of a payday loan is usually capped at a certain level depending on your state’s laws, though the typical amount is around $500. That being said, there are loan amounts that fall above and below this amount. In most cases, you won’t be able to borrow more than what you earn per pay period. 

Repayment Terms

Depending on your lender, the full amount is due your next payday (or whenever you receive your next Social Security or pension benefits), which could be anywhere from two to four weeks. Your lender has the right to cash your check or debit your bank account when it’s time to repay your loan.However, there are some states allowing lenders to extend a payday loan. If so, you can simply pay the fees and the lender will extend the loan’s due date. Or, you can agree in advance to pay back the loan in installments, though this will vary depending on state laws.

Interest Rates

Lenders either charge a flat fee or a percentage of the amount borrowed. State laws differ, but many have regulations capping the amount a lender can charge. In most cases, you’ll see the cost of a payday loan ranging anywhere from $10 to $30 for every $100 you borrow. For instance, if you borrow $300, you could see fees up to $90. This amount is the equivalent to an annual percentage rate (APR) of around 782%.In general, payday loans have a fixed rate interest (as opposed to a variable interest rate that fluctuates), as they are meant to be paid off in one lump sum payment.

Other Fees

Some states that allow borrowers to extend their loans may charge what's called a monthly maintenance fee. This amount differs depending on the amount financed, and it can only be charged at the end of every month. 

What Can a Payday Loan Be Used for?

Similarly to the wide range of possible uses for personal loans, most payday loans can be used for any purpose. This could include covering expenses during an unexpected event or paying your bills before your next paycheck arrives.If you’re unsure, it’s best to contact a payday lender in your local area to see if they impose any additional requirements.

Typical Requirements for Payday Loans

Here’s what payday leaders usually require their borrowers to provide before getting a loan:
  • Proof of income, such as a paystub or Social Security benefit statement
  • Form of government-issued identification
  • Bank account information or a check

Pros and Cons of Payday Loan

Payday loans are generally not recommended for most borrowers. That being said, there are a handful of pros compared to this type of loan’s numerous cons.

Pros of a Payday Loan

Fewer requirements compared to other loans: Payday loans don’t require a ton of paperwork compared to other types of loans, where you’ll need to show details such as your financial assets, tax returns and more. Easily accessible: Depending on the state, borrowers can either get a payday loan online, or at many brick-and-mortar locations scattered throughout the U.S.No credit check required: You don’t have to worry about not having a good credit score being a deterrent in getting a payday loan. 

Cons of a Payday Loan

Extremely high fees: These types of loans are notorious for their high fees, with APRs at least 10 times that of other types of debt like credit cards and personal loans. Even if it may seem like you’re getting the financial relief you need, the cost of a payday loan will seriously eat into the funds you end up getting.Considered predatory lenders: Many payday lenders are known to engage in actions that are deceptive. Plus, they tend to target people who have historically been more vulnerable and have low incomes. Lenders also don’t verify a borrower’s ability to repay before lending the funds.Lenders have access to your bank account: Borrowers typically need to give payday loan lenders access to their bank account. That way, the lender can recover their money by taking it from the borrower's account. Hopefully you'll pay the loan back in time — if you don't, you could face hefty fines and other fees imposed by your bank if the payday lender ends up overdrafting your account.Borrowers can fall easily into a debt cycle: If your state allows you to extend or rollover a payday loan, you'll be charged additional fees. The extra charges could make these types of loans even more unaffordable, leading you to borrow more money each time to cover expenses.You can’t build credit: Payday lenders won’t report your payment activity to the credit bureaus. Meaning, you’ll need to find other ways to build credit if you’re interested in improving your credit score

Alternatives to Payday Loans

If you need money but don’t want to take out a payday loan, there are a few alternatives to consider. 

Short-Term Personal Loans

Getting a short term personal loan — think terms of a few months — is a better alternative because you’ll be charged lower fees and interest rates. You may be subject to a credit check, but there are lenders out there willing to loan money to borrowers with bad credit. Even if you’ll be charged a higher APR than someone with excellent credit, it’s most likely lower than what you’d find with a payday lender.

Paycheck Advance

You may be able to ask your employer to get an advance on your paycheck. Essentially, you’ll receive money from your next scheduled paycheck and the amount you get will be taken out on your next pay period. 

Seek Credit Counseling

Though it’s not necessarily a solution that could help you right away, seeking help to manage your money could prove helpful in the long run so you don’t find yourself in a pinch again. With credit counseling, you’ll be able to learn what you can do to spend less than you make, or find ways to increase your income to decrease your chances of relying on debt. They can also teach you how to easily monitor your credit score moving forward.

Looking for a Short-Term Loan? Explore Personal Loan Options With Lantern

Payday loans may offer you money in the short term, but they come with numerous risks and not all that many upsides. Though you can skip stringent application requirements and a credit check, you’ll likely get hit with high fees and could very easily fall into a cycle of debt.Short-term loans can be a smart alternative. It’s smart to shop around before applying for a personal loan to find the most competitive rates and terms for your financial situation. Lantern makes comparing different loan options easy by providing a list of lenders based on what you may qualify for.
Photo credit: iStock/TARIK KIZILKAYA
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About the Author

Sarah Li Cain

Sarah Li Cain

Sarah Li Cain is a finance writer and podcast producer focusing on topics such as credit, insurance, investing, and real estate. Her work has appeared in major publications such as CNBC Select, Forbes, Redbook, and Business Insider.
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