How Payday Loans Work

During a routine car check-up, a service attendant announces to you that it will take $500 to repair your car. Normally, this cost wouldn't be a big deal, but this month you had to pay your income taxes, and you took a hit. To make matters worse, you're supposed to go on a road trip in a week. Where are you going to get $500 in time to get the car fixed?

You decide to head down to the place on the corner that advertises "Quick Cash Now." You've walked by it a hundred times but never had cause to go inside. You decide to give it a try. It's so easy! You're out the door in 15 minutes, and $500 will be deposited in your account sometime the next day. Sure, it cost you $50 in fees, but nothing beats that convenience, right?

Tengku Bahar/AFP/Getty Images
We could all use a little extra money. A payday loan could provide that money -- but it'll cost you.

That convenience is a $40 billion-per-year industry in the United States [source: Kirchoff]. This is the industry of payday lending, and it's served by more than 22,000 locations nationwide.

Booming Industry
In 2000, quick-cash companies in Washington State issued 1.8 million loans totaling $580 million. In 2004, with a large increase in the number of lending companies and locations, these numbers grew to 3.3 million loans totaling $1.2 billion [source: State of Washington].

In this article, we'll learn about the purpose of payday loans, as well as the drawbacks of these quick-cash offers.


The Purpose of Payday Loans

Payday loans are designed for people who need a quick injection of money before their next paycheck. The purpose of a payday loan is fast, easy money to take care of life's little emergencies.

A payday loan is a short-term, high-interest loan. The usual amount of the loan is between $50 and $500. You obtain one of these loans from a payday lender, a company that often offers other convenient financial services, such as foreign currency exchange, utility bill paying and license processing.

The process is actually quite simple. Here's the recipe:

  • lending store
    Tim Boyle/Getty Images
    Payday lenders take advantage of banks' disadvantages.
    Visit a payday lender. These companies often have stores, but you can also apply by phone or online. Some lenders do their business strictly online.
  • This is a no bank loan application. Usually the application consists of your contact information, banking information and employment information. The lender may ask you for the contact information of a few friends and family. The lender would call these references were you to not pay back your loan.
  • Write a check to the lender for the amount you want to borrow, or, if applying online, pledge to pay the borrowed amount by a certain date. The lender will add the finance charge, or fee. Usually lenders express their fees in $100s. Paying $15 per $100 of loan is fairly common.
  • The lender deposits the money in your bank account or gives you a check for the amount.
  • The lender holds the check you wrote for the term of the loan, usually two weeks.
  • When the term is up, the company cashes the check or debits your bank account. This pays back your loan and pays the lender's fee.
  • Rollover: If you can't afford for that check to be cashed, you can roll the loan over into another term (usually another 14 days). The lender will tack on another fee.

Ease and convenience fuel the allure of payday loans. One of the biggest advantages that payday lenders have over banks is their flexibility. Payday lenders have more locations and longer hours than most banks. Some lenders, such as some Currency Exchange locations in Illinois, are open 24 hours a day. And when was the last time you saw a bank open on Sunday?

Bad Credit? No Worries
Payday lenders rarely check your credit. Coupled with the privacy and expediency of the process, this open-mindedness makes payday lenders very attractive to people with poor credit.

In addition, the loan application process is fast. You can usually be out the door, off the phone or away from your keyboard in less than half an hour. Furthermore, you get the money in no time -- if the lender doesn't hand you a check when you apply, the money is usually electronically deposited in your account within a day.

Payday loans may sound fine and dandy. So why doesn't everyone get one? Find out on the next page.


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.

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.


Payday Loans: Hints and Tips

When you face certain financial challenges, a payday loan may be a wise and viable solution. If you face a long-term financial problem, however, you might want to consider other solutions.

  • Shop around -- there are many different payday loan companies. Make sure you aren't choosing the most expensive offer.
  • Open an emergency savings account to cover financial challenges. If your employer offers direct deposit, you may be able to deposit automatically 5 percent of each paycheck into your savings account. You probably won't even notice the difference, but the savings will be there when you need them.
  • You've heard this a hundred times: Don't borrow more than you know you'll be able to pay back quickly.
  • Take out a small loan from another institution, such as a bank or credit union. Many credit unions, in response to the financial difficulties faced by consumers who have sunk into debt by relying on payday loans, have created short-term loans with low interest rates.

  • Get an unsecured, low-interest loan from a banking institution. Since these loans are based on your credit history and do not require collateral, they are more difficult to get than a payday loan, but their rates are much lower than the rates of payday loans.
  • Talk to your credit card company about what you can do to lower your APR and/or your monthly payments.
  • APR Unlimited
    Wisconsin has the dubious distinction of having no laws governing payday lending. Theoretically, a payday loan company in Wisconsin can charge as high a fee as it would like.
    Set aside a low-interest credit card for emergency situations.
  • Take out a credit card cash advance. These rates tend to be high, though, so be careful. Plus, if you already have money charged to a card, your payments will often be credited to the lower-rate debt, leaving your high-rate debt to balloon.
  • See if you can get an extension or a more manageable payment plan to pay your bills. For example, many utility companies offer various billing plans that can help you pay your bills without going into debt.
  • Get help from a consumer credit counseling agency. These organizations can strike deals with credit card companies and other creditors to create a debt management plan to help you pay off your debt in a reasonable and manageable time period.
  • Get overdraft protection on your checking account. If you live paycheck to paycheck and payday loan to payday loan, you may find yourself incurring overdraft fees when you have unexpected costs during the month, such as the payday loan fee you forgot about when the payday lender cashed your check. These fees can put you even further into debt.

If you'd like to know more about payday loans and related topics, you can follow the links on the next page.


Lots More Information

Related HowStuffWorks Articles

More Great Links


  • Americans for Fairness in Lending. "Payday loans." (Accessed 5/4/08)
  • Consumer Federation of America. "Alaska State Information." (Accessed 5/4/08)
  • Consumer Federation of America. "Louisiana State Information." (Accessed 5/4/08)
  • Consumer Federation of America. "State Information." (Accessed 5/4/08)
  • Consumer Federation of America. "Wisconsin State Information." (Accessed 5/4/08)
  • Federal Trade Commission. "Payday Loans Equal Very Costly Cash: Consumers Urged to Consider the Alternatives." March 2008. (Accessed 5/4/08)
  • Jones, Tim. "States to payday lenders: Denied." Chicago Tribune. 3/23/08.,1,1285815.story (Accessed 5/4/08)
  • Investopedia. "Short term." (Accessed 5/4/08)
  • Investopedia. "Signature loan." (Accessed 5/4/08)
  • Investopedia. "Unsecured loan." (Accessed 5/4/08)
  • Kirchoff, Sue. "Breaking the cycle of payday loan 'trap.'" USA Today. 9/19/2006. (Accessed 5/4/08)
  • Marples, Gareth. "How Payday Loans Work - A Last Resort?" Net Guides Publishing, 2004. (Accessed 5/4/08)
  • PayDayOne. "How it works." (Accessed 5/4/08)
  • Pritchard, Justin. "What You Need to Know Now About Payday Loans." (Accessed 5/4/08)
  • State of Washington Department of Financial Institutions. "Payday Lending Report, Statistics & Trends 2004." (Accessed 5/4/08)