How Payday Loans Work

Payday loans are short-term cash loans based on the borrower's personal check held for future deposit or on electronic access to the borrower's bank account. Borrowers write a personal check for the amount borrowed plus the finance charge and receive cash. In some cases, borrowers sign over electronic access to their bank accounts to receive and repay payday loans.

Lenders hold the checks until the next payday when loans and the finance charge must be paid in one lump sum. To pay a loan, borrowers can redeem the check by paying the loan with cash, allow the check to be deposited at the bank, or just pay the finance charge to roll the loan over for another pay period.

Payday Loan Terms

Payday loans range in size from $100 to $1,000, depending on state legal maximums. The average loan term is about two-weeks. Loans typically cost 400% annual interest (APR) or more. The finance charge ranges from $15 to $30 to borrow $100. For two-week loans, these finance charges result in interest rates from 390 to 780% APR. Shorter term loans have even higher APRs.

Cost Compared with Other Cash Loans

Payday loans are extremely expensive compared to other cash loans. A $300 cash advance on the average credit card, repaid in one month, would cost $13.99 finance charge and an annual interest rate of almost 57%. By comparison, a payday loan costing $17.50 per $100 for the same $300 would cost $105 if renewed one time or 426% annual interest.

Requirements to Get a Payday Loan

All a consumer needs to get a payday loan is an open bank account in relatively good standing, a steady source of income, and identification. Lenders do not conduct a full credit check or ask questions to determine if a borrower can afford to repay the loan.

Payday Loan Industry

Payday loans are made by payday loan stores, check cashers, and pawn shops. Some rent-to-own companies also make payday loans. Loans are also marketed via toll-free telephone numbers and over the Internet.

At the end of 2006, the Center for Responsible Lending reported about 25,000 payday loan outlets in the United States and annual loan volume of at least $28 billion, with almost $5 billion in loan fees paid by consumers. Industry analysts estimate 2008 annual loan volume at stores was $35 billion, with roughly $5.5 billion in loan fees paid by consumers.  The industry estimate a 2008 online payday loan volume at $7.1 billion.

Legal Status for Payday Lending

High cost payday lending is authorized by state laws or regulations in 35 states. Fifteen states and the District of Columbia protect their borrowers with reasonable small loan rate caps.  The Arkansas Supreme Court ruled that the Arkansas payday loan law was unconstitutional.  In recent years, Oregon, Ohio, New Hampshire and the District of Columbia have reimposed rate caps.  For more information, click on Legal Status.

New Protections for Service Members and Dependents

New federal protections for Service members and their families took effect October 1, 2007. The Department of Defense regulations apply to payday loans, car title loans and tax refund loans. Lenders are prohibited from charging more than 36 percent annual interest including fees; taking a check, debit authorization or car title to secure loans; and using mandatory arbitration clauses in contracts for covered loans. For more information, click on Issues.

Tactics to Evade State Small Loan and Usury Laws

Some lenders use sham transactions, such as Internet access with a rebate schemes, to cloak loans. In Texas, most lenders operate as unregulated "credit services organizations" to evade state small loan limits set by the Texas Finance Commission under the small loan law. The Federal Deposit Insurance Corporation took enforcement action to stop a dozen or so small banks from "renting" their charters to help payday lenders operate in states that do not authorize these loans or interest rates. Payday lenders revamped their single payment loans into high cost installment loans to evade state law restrictions in Illinois and New Mexico.  In Virginia, some lenders morphed payday loans into open end lines of credit to escape rate caps. 

Debt Traps

Payday loans trap consumers in repeat borrowing cycles due to the extreme high cost to borrow, the very short repayment term, and the consequences of failing to make good on the check used to secure the loan. Consumers have an average of eight to thirteen loans per year at a single lender. In one state almost sixty percent of all loans made are either same day renewals or new loans taken out immediately after paying off the prior loan.

Risk and Cost of Checks for Loans

Every unpaid loan involves a check that is not covered by funds on deposit in the borrower's bank account. Failure to repay leads to bounced check fees from the lender and the consumer's bank. Returned checks cause negative credit ratings on specialized databases and credit reports. A consumer can lose her bank account or have difficulty opening a new bank account if she develops a record of "bouncing" checks used to get payday loans.  Research indicates that payday loan users are almost twice as likely to file for bankruptcy as borrowers who are turned down for a payday loan.

Coercive Collection Tactics from Check Holding

Basing loans on personal checks leads some lenders to using coercive collection tactics. Some lenders threaten criminal penalties for failing to make good on checks. In some states lenders sue for multiple damages under civil bad check laws.

Internet Payday Lending

Internet payday lending adds security and fraud risks to payday loans. Consumers apply online or through faxed application forms. Loans are direct deposited into the borrower's bank account and electronically withdrawn on the next payday. Many Internet payday loans are structured to automatically renew every payday, with the finance charge electronically withdrawn from the borrower's bank account.