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How Payday Loans Work

The Drawbacks to Payday Loans

The biggest drawback to payday loans is the price to the customer. Let's take a closer look at the fees charged by payday lenders.

If you were to take out a two-week payday loan for $100 and were charged a fee of $10, you would owe $110 at the end of those two weeks. Look at the math.

$10 / 14 days = $0.71 per day

OK, $0.71 per day may not seem like much, but what if you couldn't afford to pay off this loan for a year?

$0.71 x 365 days = $261

At the end of the year, on top of the $100 you borrowed, you would owe $261. That means your Annual Percentage Rate (APR) is 261 percent.

The standard payday loan fee in many states is $15 per $100. How high can you go?

$15 / 14 days = $1.07 per day

$1.07 x 365 days = $391

APR = 391 percent

As you can see, for two weeks, a $10 or $15 fee is steep for what you're borrowing, but manageable. But when you can't pay the loan back after two weeks and you have to roll it over, your fees start to add up. Although most states regulate how much a payday lender can hold you accountable for over a long period of time, payday loans can be extremely costly if you use them frequently or roll the loans over for several terms.

foreign currency exchange
Bertrand Langlois/AFP/Getty Images
Some payday lenders offer other financial services, such as foreign currency exchange.

The speed, ease and convenience of payday loans make them attractive to many low-income workers who live paycheck to paycheck and struggle to pay their bills on time. Unfortunately, when people habitually resort to payday loans to manage their finances, they inevitably sink further and further into debt because of the high cost of the loans.

Banks, the federal government, state governments and citizens accuse payday lenders of taking advantage of low-income workers. Concerned organizations say that payday loans are designed to profit from borrowers' poor financial situations. State governments have even passed laws to regulate this controversial lending method. Recently, Oregon placed a 36 percent APR cap on small loans, such as payday loans.

Similarly, payday lenders can't charge higher than 36 percent APR on loans to military personnel. The Federal Trade Commission advises military personnel to seek financial assistance from such military organizations as Coast Guard Mutual Aid, Air Force Aid Society, Army Emergency Relief and Navy and Marine Corps Relief Society [source: FTC].

Borrowers in Washington got some help in 2003 when new laws required lenders to extend an installment plan to a borrower after the borrower had taken out four successive loans from the same company [source: State of Washington].

Next we'll take a look at some alternatives to the potentially costly payday loan.

Even More APRs
Payday lenders in Alaska can charge up to $20 per $100 of loan. This equates to a 521 percent APR. The $25 maximum fee in Louisiana comes out to a staggering 652 percent APR.