Payday Loans: What They Are & Risks - A Comprehensive Guide

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Payday loans are designed to keep desperate borrowers on the hook.

What are payday loans? You know those "get cash fast" places you hear about? Those are payday loan lenders -- and they are not your friend. Payday lending depends on desperate people with few other options to keep their doors open.

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How they work

Let's say your car breaks down on the side of the road or your electricity has been shut off due to nonpayment. You have no money in the bank, and your credit score is low. A payday lender might seem like a good idea. After all, they require no credit check and promise to get you the money you need fast.

According to a personal loan study by The Ascent, you could end up paying 400% or more in interest due to the way payday loans are designed. (Interest rates as of 2019 ranged from 154% to 677%.) The average interest rate on a credit card is 16.16% according to the CreditCards.com Weekly Credit Card Rate Report. And, at the time of this writing, the annual percentage rate (or APR) on the best personal loans for bad credit caps out around 35.99%. Given those statistics, charging more than 400% is the act of a predatory lender.

Part of the problem is this: In 2019, 33 states still allowed payday loans. (Some other states have put an end to these predatory lending practices.) Not one of the 33 states that still lets payday lenders operate limits the amount of interest charged.

How they keep you hooked

Whether you visit a payday lender's physical location or take out an online payday loan, lenders make it easy. All they require is proof of identification, proof of your gross monthly income, and a postdated check. You tell them how much you want to borrow, and they instruct you to write a check for the amount you borrowed, plus fees. They have you postdate the check by two weeks.

If you can't pay the loan back in full by the due date (and the average payday borrower can't), you owe them the original amount you borrowed, any fees they tacked onto the loan, and the interest accumulated in those two weeks. Let's say you originally took out a small loan of $500. Two weeks later, you could owe $600 or more.

Hey, that's okay -- at least according to the payday loan lender. They'll give you another loan to pay off the first loan. Now, you'll need to borrow the $600 (or more) you owe on the original loan and another round of loan fees. Between the principal, fees, and finance charge, you'll likely end up owing $700 or more two weeks later.

Payday lenders are not naïve. They know that you have other financial obligations. It's in their best interest if you keep borrowing to pay off previous loans. When you finally pay the debt in full, they end up with more money due to excessive fees and interest. Even small dollar loans can end up being very expensive.

A way out

We can't tell you about payday loans without suggesting other ways to find money when you're in a pinch.

Consider a cash advance

If you have a credit card, a cash advance loan may be the answer. Cash advances typically carry a higher interest rate than regular credit card purchases, so we wouldn't normally suggest you take one out. However, when the choice is between a cash advance with an APR of 30% or a payday loan with an APR of 400% or more, a cash advance is the clear winner. Most cash advances come with fees and begin to accrue interest immediately, so make it a point to pay it off as quickly as possible.

Turn to friends and family

If you need only enough to get you through until your next payday, help from a friend or family member might be the ticket. Before you borrow, though, make sure you can repay the loan as promised. There are few things worse than leaving someone else in the lurch because you couldn't uphold your end of the deal.

Check charitable organizations

Let's say you paid to repair your car but now don't have money to feed your family. A number of organizations offer services to help. There's aid available for just about everything -- from groceries to utility bills to transportation. Need Help Paying Bills offers a long list of organizations, who they help, and how to contact them.

Apply for a bad credit loan

As mentioned, borrowers with poor credit scores may still qualify for a personal loan for bad credit. Your interest rate is likely to be high, but it's better than paying 400% interest.

Taking out an installment loan like this offers several advantages:

• You'll know exactly how much your monthly payment will be and when the loan will be paid in full.
• You can "set it and forget it" by scheduling automatic monthly payments from your bank account.
• If you want to pay the loan off quickly, you can choose a short loan term.
• Personal loans are available from local banks, credit unions, and online lenders.
• You can avoid a predatory high interest rate.
• As long as you stick to the repayment plan, your credit score is likely to go up.

In short, trying one of these options instead of becoming a victim of predatory payday loans is good for your bottom line.

The Ascent's Best Personal Loans for 2021

The Ascent team vetted the market to bring you a shortlist of the best personal loan providers. Whether you're looking to pay off debt faster by slashing your interest rate or needing some extra money to tackle a big purchase, these best-in-class picks can help you reach your financial goals. Click here to get the full rundown on The Ascent's top picks.