How Do Payday Loans Work?

Payday loans sound like a fast, easy way out of trouble. You take out a short-term loan for a small amount—maybe only a few hundred dollars—and pay it back when your paycheck comes in. But are payday loans really that simple? How do payday loans work, and are they a sensible choice when you’re in financial trouble?

If you’re curious about payday loans, you’re in the right place. We’ll unpack payday loans in this guide, and we’ll reveal some of the best alternative finance options for cash flow issues.

Payday Loans in the COVID Era

The coronavirus pandemic made a major impact on the economy and on the jobs market. Many people ended up unemployed and unable to pay basic expenses like rent and utility bills. Meanwhile, payday lenders did big business. According to Bloomberg, payday lenders made huge profits in 2020—in spite of increased unemployment benefits and federal relief money.

As the economy recovered, people who took out payday loans began to pay them back. Unfortunately, by then, many of them had already fallen into the “payday lender trap.” Initially offered small, short-term loans with high interest rates—sometimes up to 664%—they became trapped in a cycle of borrowing and found themselves increasingly poorer.

The Myth of the Easy Payday Loan Fix

Most financial experts agree that payday lenders are predatory lenders. They “help” borrowers in the subprime market but actually make a lot of money in interest and leave people poorer. Take this example, for instance.

Mary lives paycheck to paycheck. One day, her car breaks down, and she doesn’t have enough in her savings account to fix the vehicle. Mary needs to get to work, so she takes out a small $500 payday loan, agreeing to pay it back the following week. When payday comes around, the loan—plus hefty interest and fees—swallows up far more money than Mary expects.

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Mary thought her payday loan would plug a hole and leave her better off in the long run. Unfortunately, the loan payback amount means Mary doesn’t have enough money to pay her electricity bill. The solution? Another payday loan.

That, in a nutshell, is the payday lender debt trap.

The Dark Payday Loan Reality

Borrowers like the fictional Mary above are all too real—and too common—in America today. When payday lenders “helpfully” suggest bankrolling payday loans into new payday loans, interest compounds and fees accrue. Every time borrowers pay their loans back, they pay more and more. Eventually—and this doesn’t take long at all—they owe more than they bring in.

If you think that sounds unfair, you’re not wrong. Payday lenders are considered so predatory that in 2017, the Consumer Financial Protection Bureau (CFPB) launched a set of new rules to make payday lending safer and fairer. Unfortunately, the subsequent administration blocked the new rules and later blocked most of them from going into effect.

Right now, in fall 2021, payday loans are legal in 34 states, 31 of which allow high-interest payday loans. Payday loans are illegal in 16 other states, including New York, New Jersey, Arkansas, South Dakota and North Carolina. The state of Georgia even considers payday loans a form of racketeering.

What Are the Dangers of Payday Loans?

The main danger of a payday loan is undoubtedly the payday loan trap. Like Mary, you could find yourself owing more than you make, literally trapped in an endless cycle of borrowing and paying back ever-greater loans with interest and fees tacked on.

While difficult to tackle, the payday loan trap isn’t impossible to escape. A recent Payday Lending in America survey found that most borrowers eventually got out of debt via a cash infusion from a relative or friend. Other ways to wriggle out of the net include:

Requesting an extended payment plan and then not borrowing any more from your payday lender.
Paying off your loan with a different kind of credit, like a credit card or a conventional personal loan.
If you think your lender has broken the law, filing a complaint with your state regulator or the Consumer Financial Protection Bureau.

Avoiding the Payday Loan Trap

The best way to avoid the payday loan trap is to nevertake out a payday loan in the first place. If you’re reading this article and you haven’tyet taken out a payday loan, stop and think about the alternatives available to you.

If you have access to a credit card—even if it’s a high APR card—using it willsave you money over a payday loan. If you put your expense on a credit card, you can control the amount you pay back and, if you need a little breathing room, you can slow down your payment schedule without incurring astronomical fees.

Let’s compare options here:

Payday loan. If you borrow $500 at 400% interest and pay it all back just 15 days later, your total repayment amount will be $622. In total, you’ll pay $122 for your loan.
Personal loan. If you borrow the same $500 at 14.99% via a standard personal loan and pay it back over 12 months, you’ll pay $45 a month. In total, you’ll pay back $542—so your loan will cost you $42.
Credit card. If you put $500 on a credit-builder credit card with 31% APR and pay it back over 12 months, you’ll pay $49 a month. In total, you’ll pay back $588—or $88 for your loan.

Clearly even credit-builder credit cards have a serious advantage over payday loans—plus using a credit builder card responsibly can help you improve your credit. If your credit improves, you may never need to consider a payday loan again. In contrast, payday loans aren’t generally reported at all—so you won’t boost your credit score even if you pay back your loan on time.

There are lots of reasons to avoid payday loans—even if you’re in a really tight spot. Personal loans and credit cards—even high-interest credit-builder cards—are far less expensive and help to build your credit. Whatever you do, don’t fall for the “quick fix” sales tactic, and don’t borrow more than you can easily pay back.