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How Do Payday Loans Work?

Allison Martin
Payday loan application

If you're strapped for cash until payday and desperately need to cover an expense, a payday loan may be a viable option. However, you should have a thorough understanding of what payday loans are and how they work before applying.

What Is a Payday Loan?

The Consumer Financial Protection Bureau defines a payday loan as "a short-term loan, generally for $500 or less, that is typically due on your next payday." It is often used by individuals who are faced with a financial emergency with few to no other options available to obtain cash quickly.

How Payday Loans Work

When you are approved for a payday loan, the funds are typically given to you in cash, deposited electronically into your bank account, or loaded onto a prepaid card.

Qualification Criteria

If you are planning to apply for a payday loan, you need to first consider the qualification criteria, which includes documentation and meeting the terms and conditions.

Documentation Requirements

To apply for a payday loan, most lenders will ask that you provide the following:

  • Recent paystubs: These are used to verify you are, indeed, employed.

  • Bank account information (routing and account number): The lender may request this information if they wish to withdraw the funds from your bank account on the due date in lieu of depositing a paper check.

  • Personal references: Some payday lenders also request you provide a list of personal references.

Upon approval, you will have to provide a post-dated check. It should equal the amount borrowed plus the corresponding fee, and the lender will cash it on the due date, which is typically on or a day following your next payday.

Terms and Conditions

You must also be mindful of the true costs of payday loans. Since no credit check is required, the lender will more than likely assess a hefty finance charge to hedge against the risk of default. "The cost of the loan (finance charge) may range from $10 to $30 for every $100 borrowed," notes the Consumer Financial Protection Bureau.

To illustrate, if you borrow $200 on a 14-day loan term, you will be assessed an APR anywhere between a whopping 260.71 and 782.14 percent. Therefore, it's in your best interest to shop around for the lowest rate or find more cost-effective alternatives, such as a personal loan from a relative, if possible. To calculate the APR on your payday loan, use the online tool provided by Calculator Pro.

Fortunately, the Truth in Lending Act (TILA) mandates payday lenders disclose the true cost of loan.

If You Can't Repay

If the due date rolls around and you don't have the cash on hand to pay off the outstanding balance, which is equal to the amount borrowed and the finance charge, you may be able to extend the loan term. However, this will come at a steep cost as additional fees will be applied to the overall amount you already owe.

Where to Find

There are several online and brick and mortar lenders that provide payday loans. Also, check with your financial institution to inquire about payday loan options that may be available to you.

Reputable online payday lenders include LendUp, National Payday, and Cash America. There are also several brick and mortar payday lenders, including ACE Cash Express, Amscot, and Advance America. All have a Better Business Bureau (BBB) rating of A or higher.

An Important Consideration

When evaluating payday lenders, both brick and mortar and online, be sure to review their BBB rating and customer reviews. By doing so, you'll avoid scams and know exactly what you're getting into when you apply for a payday loan. You may also discover that it may be worthwhile to seek other alternatives.

How Do Payday Loans Work?