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What is a Payday Loan?

what is a payday loan?

Personal Finance

What is a Payday Loan?

If you are in a hurry to buy a small amount of money, you might be considering a payday loan. Although you can borrow small amounts of money, you will borrow at a very high-interest rate.  Before you apply for this quick access to credit, you need to know what exactly is a payday loan and if it is a good idea for you.

How Do Payday Loans Work?

You might also know payday loans as cash advance loans or check advance loans. They are unsecured, high-interest loans that give you access to small amounts of cash usually less than $500, but, some lenders will lend up to $1,500. Because the loans are unsecured you do not need to undergo a credit check and do not require collateral like your car, house, or a cosigner.

To get the cash, you write a post-dated check that the lender will deposit on the final day of the loan. This date is usually your next payday when you will have enough money in your account to pay back the loan.

This is why these types of loans are often called “payday loans.” You borrow the money and repay it when you receive your next paycheck.

Most payday loans have a repayment period of 14 days or 30 days, whenever the next payday is. Some lenders will also allow you to renew the loan for several months if you can make a small monthly payment. Some lenders require 4% of your next paycheck and others might require 34%.

With short lending periods and steep interest rates, these loans are often associated with borrowers with low incomes, bad credit, or live paycheck to paycheck.

Payday Loans Interest Rates

Payday loans are infamously known for their high-interest rate. These are one of the few financial loans that have a higher interest rate than credit cards.

Every state has different regulations about payday lending interest rates including limits to interest rates and service fees.

The average interest for a payday loan can have an annualized APR of 459% or higher. That equates to a 38% finance charge (interest rate) every 30 days!

Examples of Payday Loan Fees
Source: acecashexpress.com

In addition to the interest rate, the lenders also charge an advance fee that is a percentage of the borrowed amount. The fee can be 5% to 20% of the cash advance amount depending on your state laws.

While payday loan interest rates are astronomically high, they might not seem high because they are for small amounts of money that are usually repaid within a few months. But, the interest charges accrue rapidly. With interest rates near 500%, you will pay as much in interest as you originally borrowed every few months.

Repaying Payday Loans

Payday loans can be repaid at any time. Federal law states there are no prepayment penalties if you repay a payday loan early. Doing so will also reduce the daily interest charge as well. You will pay the least amount of fees when you repay the entire balance with your next paycheck.

It is also possible to have multiple payday loans at a single time. Having multiple loans can greatly increase the cost of borrowing and make it harder to repay the loans. This is because you have an advance fee with each loan plus the very high interest rates that quickly add to the cost of the loan.

And, each time you extend your loan, you have to pay a new advance fee that also adds to the cost of the loan.

Despite the high interest rates and additional fees, payday loans only have a chargeoff rate near 3%. While they are expensive for the borrower, most borrowers do repay the loans.

Advantages of Payday Loans

Payday loans are a very expensive form of credit but they do have some advantages:

  • Instant access to cash
  • No credit check required
  • No collateral required (i.e. unsecured loan)
  • People with bad credit can get approved with proof of employment

Disadvantages of Payday Loans

Let’s now look at the downside of payday loans and why they might not be the best option.

  • Expensive fees and interest rates
  • Low lending amounts
  • Expenses can be covered from an emergency fund first
  • Payday lenders can “prey” on borrowers with low incomes or poor credit

Summary

Payday loans give you quick access to cash if you need couple hundred dollars to pay a bill before your next paycheck. These are also some of the most expensive loans you can apply for because they are intended for short-term borrowing only. Because payday loans are so expensive, you should only consider these loans an option of last resort when all other financial options have been exhausted.

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