You’ve probably heard of payday loans, even if you’ve never gotten one. And good for you if you haven’t heard of payday loans because they are a really bad idea.
Let’s put it this way: they’re one of those financial arrangements that’s incredibly easy to get into, but painfully difficult to get out of.
Let’s unpack what payday loans are, how they work, and why you should always look for alternatives to this type of loan.
What Is a Payday Loan?
A payday loan is a very short-term loan. Short-term as in no more than a few weeks. They’re usually available through payday lenders operating out of storefronts, but some are now also operating online.
Payday loans work best for people who need cash in a hurry. That’s because the entire application process can be completed in a matter of minutes — literally.
Payday lenders will verify your income and that you have a bank checking account. The income check is to determine your ability to repay, while the bank account check is to confirm how you will pay.
How Do Payday Loans Work?
When your loan is approved, the funds are deposited into the verified bank account. But even more important, the lender will require that you write a postdated check in payment of both the loan amount and the interest charged on it.
For example, let’s say that you’re granted a $500 loan on October 16, at 400% APR. (And yes, 400% APR is pretty standard for payday loans.) Since the loan will require repayment within two weeks, you will write a check back to the lender that’s dated for October 30. The check will be for $575: $500 for their loan repayment, plus $75 for two weeks’ interest.
The postdated check ensures that the lender will be paid back by the scheduled date and that they won’t have to chase you to get it. Borrowers tolerate the postdated check arrangement because the other major component that lenders normally look at — namely, credit history — is ignored by payday lenders.
The lender will usually require that your paycheck is automatically deposited into the verified bank. The postdated check will then be set to coincide with the payroll deposit, ensuring that the post-dated check will clear the account.
That’s why they’re called “payday loans.”
Why People Take Out Payday Loans
People with poor credit are natural clientele for payday loans. The borrower can apply for the loan, and not be at all concerned if their credit is either ugly or nonexistent.
People with little or no savings represent another natural market. A 2022 Lending Club report found that 64% of Americans are living payheck to paycheck.
And a 2022 survey by Bankrate found that 56% of Americans would be unable to cover an unexpected $1,000 bill with their savings.
Add to that current inflation rates and post-pandemic financial struggles, and you can see the enormous potential market for payday loans, and why they’re so stubbornly popular.
Since bad credit and a lack of savings often go hand-in-hand, payday lenders have a built-in market. And while many people can still get by day-to-day without having any savings, an emergency situation creates a need for immediate cash.
For example, say you have bad credit, no savings, and car trouble. You find out that it will cost $700 to fix your vehicle. You need the car to get to work, and since you have no available credit and no savings, you turn to payday lenders. You may have no idea how to come up with $700 (plus interest) in two weeks, but the loan buys you some time.
According to Pew Charitable Trusts, 12 million Americans take out payday loans each year, spending $9 billion on loan fees. Meanwhile, federal lawmakers are working to reduce payday loan rates from 400% to 36%.
Payday loans are often used in place of emergency savings accounts, although many people, unfortunately, also use them for regular living expenses.
Read more: Emergency Funds: Everything You Need to Know
What’s So Bad About Payday Loans?
The most obvious problem with payday loans is the cost. We just did an example of a borrower who pays $75 in interest for a $500 loan. If that was the cost of interest for a full year, the interest rate would be 15%. That would be a decent rate for someone who has either bad credit or no credit, and is taking an unsecured loan.
But the $75 is the interest charged for just two weeks. And what makes it even more concerning is the fact that this interest rate is being charged to the people who can least afford it. If a person doesn’t have $500 today, they probably won’t be any more likely to have $575 in two weeks. But that’s what they’ll have to come up with.
And that’s why it gets worse.
The REALLY Bad Part About Payday Loans
People who take payday loans often get locked into an ongoing cycle. One payday loan creates the need for a second, which creates the need for a third, and so on.
The problem is that the borrower usually needs to take another payday loan to pay off the first one. The whole reason for taking the first payday loan was that they didn’t have the money for an emergency. Since regular earnings will be consumed by regular expenses, they won’t be any better off in two weeks.
The lender might provide continuous financing by rolling over the loan every two weeks. The borrower will have to pay the interest every two weeks, but the original loan balance will remain outstanding.
Because the borrower will have to pay $75 every two weeks, he’ll end up paying $1,950 in interest over a year, in order to gain the one-time benefit of the $500 loan.
This is another reason why payday loans rarely exceed $1,000. The payday lenders are keenly aware that the likelihood of being repaid declines with the size of the loan.
And should you be unable to make good on your payday loan, lenders are among the most savage when it comes to collecting. You will not only be hounded by collection calls and threats, but you almost certainly will be slapped with a court judgment.
Alternatives to Payday Loans
I want to recommend two good alternatives, so you can steer clear from payday loans. Remember: payday loans trap you into a cycle that’s almost impossible to get out of.
One of the best alternatives to a payday loan is to take out a personal loan from a reputable lender. While personal loans still accumulate interest over time, the interest rate is much, much lower than predatory payday loans. Even borrowers with poor credit may qualify for a personal loan from some lenders.
Loan comparison tools like Monevo can help you quickly and easily compare lenders, check rates, and see which loans you may prequalify for. Monevo lets you compare over 30 different banks and lenders, and features a quick and easy rate check process that won’t affect your credit score.
The best part, however, is the fact that Monevo is completely free to use, and many of the lenders Monevo partners with can have funds deposited into your bank account in as soon as one business day.
Read more: Best Emergency Loans for Bad Credit
Another option is a cash advance from Empower. Check your eligibility in the app and, if you qualify, you’ll get up to $250¹ deposited directly into your bank account. You won’t pay late fees or interest on the cash advance. Empower will simply take the amount that was advanced out of your next direct deposit, as agreed in the app.
But cash advances aren’t the only reason to consider Empower. Your account will include spend tracking that helps you make sure you stick to your budget. The money in your Empower Card will earn interest with no overdraft fees and no minimums, and you can get paid up to two days early.**Empower is a financial technology company, not a bank. Banking services provided by nbkc bank, Member FDIC.
How to Avoid Needing a Payday Loan Next Time
The two most basic reasons why people fall into the payday loan trap are bad credit and a lack of savings. It’s not easy to overcome either problem, let alone both. But since payday loans trap you into a cycle that’s almost impossible to get out of, it’s worth making the effort.
Overcome Bad Credit
Obviously, you’ll need to make all of your debt payments on time from now on. You should also avoid incurring any new debt, since it will be difficult to repay.
But there is another exception to that rule, and that’s a credit builder loan. These are loans that are designed specifically for people with either no credit or bad credit. They’re offered by some banks and credit unions and are well worth having.
A credit builder loan works by giving you a loan in which the proceeds are deposited into a savings account. The monthly payments are automatically drafted out of the savings account by the lender to pay the loan. Loans are for small amounts and have reasonable interest rates, with terms of anywhere from 12 to 24 months.
Let’s say that you take a credit builder loan for $500. The loan will be for 12 months at 10% interest. The loan proceeds will immediately be deposited into a dedicated savings account in your name (you will not have access to the funds in the account). Each month the bank will withdraw an amount sufficient to cover the principal and interest.
The bank will then report your good payment history to the credit bureaus. The idea is that building good credit will help to offset a history of bad credit. This will increase your credit score more quickly than simply paying off bad debt.
Best of all, you won’t have to be concerned with making the monthly payments. And as far as cost, you will only have to deposit enough money into the bank account to cover the interest for one year. At 10% interest, that will be something less than $50 for the year.
Overcome a Lack of Savings
The only way to eliminate the need for payday loans is to become self-funding. And the only way to do that is by having cash in the bank. You’ll be able to use savings when an emergency hits, rather than turning to high-priced lenders.
But how do you build up savings if you’ve never had much in the past?
It will require sacrifice on your part. But, really, the best alternative to a payday loan is to be super disciplined about every penny you earn. You may need to be ruthless about cutting unnecessary expenses.
Or, you may need to increase your income by picking up a second job or side hustle for as long as it takes to get enough money into your savings account to give you some budgetary breathing room.
You could also consider selling off anything that you have but don’t need. For example, having a couple of garage sales or selling some stuff on Craigslist could easily raise a few hundred dollars.
You’re going to have to continue topping up your savings account to prepare for future emergencies. But the more you do it, the more of a habit it becomes, until you no longer notice those extra bits of cash going from your spending into your savings.
It won’t be easy, but it’s the only way to avoid the dangerous and costly payday loan cycle.
Read more: Which Budget System Is Best for You?
Payday loans are designed to trap you in a cycle of debt. When an emergency hits and you have poor credit and no savings, it may seem like you have no other choice. But choosing a payday loan negatively affects your credit, any savings you could have had, and may even cause you to land you in court.
There are alternatives to payday loans — and good ones. If you need a payday loan, choose one of these other options because getting a loan for 300-500% interest over a few weeks is just never, ever the way to go.Empower Disclosure - * Eligibility requirements apply. * Early access to paycheck deposit funds depends on the timing of the employer's submission of deposits. Empower generally posts such deposits on the day they are received which may be up to 2 days earlier than the employer's scheduled payment date. Cashback deals on Empower Card purchases, including categories, merchants, and percentages, will vary and must be selected in the app. Cashback will be applied automatically when the final transaction posts, which may be up to a week after the qualifying purchase.