Payday Loans: Pros, Cons and Cautions

Need money fast? Don’t want to go through the hassle of applying for a typical loan and waiting for approval? A payday loan offers quick, convenient cash when you need it with few questions asked. But it comes with a serious catch.

Take the time to answer critical questions before getting a payday loan, such as how do payday loans work? Who is eligible for one? What interest rate will I be charged? And are there better options?

What are payday loans?

Loans come in many different types, sizes, and forms. If you seek to buy a home, you pursue a mortgage loan. You can obtain a home equity loan when you want to make home improvements. A new car can be financed via an auto loan. Higher education is typically funded via student loans. And a personal loan can be had when you need cash for virtually any reason.

One type of personal loan is called a payday loan. This is an unsecured loan, which means it does not require you to put up collateral, like a home, to secure the funding. A payday loan is typically a short-term but high-cost loan that often must be paid back by your next payday, usually in a single payment or when income is received from a different source such as Social Security or a pension.

The deadline date for repayment, indicated in the payday loan agreement, is commonly two to four weeks from the date the loan was created.

The funds provided by the lender come in the form of cash, check prepaid debit card, or electronic money deposited into your bank account.

What are the pros and cons of a payday loan?

Perhaps no loan option is as quick or dependable as a payday loan. That’s because it’s relatively simple to apply and qualify for this financing, and you usually get the money within 24 hours.

The biggest drawback to a payday loan is that this type of loan tacks on an exorbitant fee for the convenience of quick cash. The lender may charge, for example, a fee of $10 to $30 for every $100 you borrow. That equates to an annual percentage rate (APR) that can exceed 400%. Compare that to the APRs on many credit cards, which charge between 12% and 30%.

Say you borrow $500. That means you may have to pay back $650 total ($500, plus $30 for every $100 borrowed) within two to four weeks.

(Depending on your state’s laws, there may be a cap on how much the payday lender can charge for fees. Also, the federal Military Lending Act has special protections in place for active duty service members and their dependents that impose a ceiling of 36% on the Military Annual Percentage Rate a payday loan can charge these borrowers.)

Also, there is a ceiling on how much you can borrow via a payday loan. According to the Consumer Financial Protection Bureau, the usual loan limit is $500 or less (many states set a cap on payday loan sizes).

“Plus, payday loans also have significantly shorter repayment periods, so the default rate for payday loans tends to be much higher than for other lending options,” says Mila Garcia, co-founder of iPaydayLoans in Kirkland, Washington.

Another disadvantage associated with payday loans is that they may be difficult to find in your area. In fact, some states do not allow payday lending at all.

“Additionally, while a payday loan generally won’t hurt your credit, not paying it back will,” cautions Anthony Martin, CEO of Choice Mutual. “If you find yourself unable to pay back your payday loan, it can be sent to a collections agency, negatively affecting your credit score.”

How do you qualify for a payday loan?

As mentioned, you don’t need collateral to be eligible for a payday loan. And a payday lender typically does not consider your capacity to pay back the loan while meeting your other financial responsibilities. In other words, it’s relatively easy and quick to qualify for a payday loan. The lender may not even check your credit. The amount you are approved to borrow will depend on your anticipated short-term income.

“These loans can often be applied for online and are processed very quickly, with most payday lenders even open to accepting borrowers with low credit scores. All you need is a bank account and proof of income that verifies your ability to repay the loan in time,” says Garcia.

Esther Strauss, with Step By Step Business in Austin, Texas, says the application process is simple.

“Simply walk into a payday lender’s office, show your identification and a paystub, and you’ll probably get your money on the spot or by the next day. The same is true of online payday loans. You apply online, but the money will be electronically transferred to your bank account,” explains Strauss.

Who are good candidates for a payday loan?

Payday loans are ideal options for those in need of fast cash for minor emergencies, “like unexpected car repairs or urgent utility bills, as most credit lenders will be able to deposit these funds in your account within 24 hours after approval,” Garcia notes.

“They’re often targeted at people who live paycheck to paycheck and need $500 to $1,000 as soon as possible to cover their costs,” says Shawn Plummer, CEO of Atlanta-based The Annuity Expert.

How do you repay a payday loan?

To pay back a payday loan, you typically write the lender a post-dated check for the full balance – including any fees involved. Alternatively, you can permit the lender to electronically deduct the funds from your bank, prepaid card, or credit union account. This way, if you don’t repay the loan by the due date, the lender can cash your check or electronically debit the money from your account.

Payday loans are usually set up to be paid off in a single lump-sum payment. Some state laws allow lenders to renew or roll over a loan at its due date, letting the consumer merely pay the fees due while the due date for the remaining balance gets extended. Depending on the lender and the payday loan, the loan may be structured to be repaid over a longer period via installments.

What are better alternatives to payday loans?

There are less expensive options than a payday loan you can pursue.

“Many banks and credit unions now offer similar quick personal loan services for much smaller fees,” continues Plummer. “It’s better to turn to your trusted local credit union than walking into a payday lender and asking for this type of loan. Compare the interest rates, and you’ll typically find much better terms than what you get from a payday lender.”

Or, consider a traditional personal loan instead.

“Personal loans are generally easy to qualify for, charge less interest and fees, and offer an easier payback schedule than a payday loan,” recommends Martin.

Instead, consider a credit card cash advance, “which can be a better alternative to a payday loan. It still costs money, but much less money than a payday loan,” adds Strauss.

Most experts are in agreement about payday loans.

“In almost all cases, a payday loan should be avoided and other options sought,” Strauss advises. “Too many people get themselves into trouble, and their payday loans end up going to collections, which limits their ability to get better forms of credit in the future.”

Garcia agrees. “It’s often best to not pursue a payday loan unless you have exhausted all other options and are completely confident that you can afford to repay the full amount with interest on time,” she says.