What Is a Payday Loan and How Does It Work?
Payday loans represent a risky form of borrowing that we recommend you stay away from. They are usually issued for small amounts, commonly $500 or less. Many states set limits on their size. Depending on your state laws, payday loans are available through either storefront payday lenders or online.
These loans usually need to be repaid by your next payday, typically two to four weeks from the date the lender issued the loan. Payday loans come at a high cost, as the fees can range from $10 to $30 for every $100 borrowed.
The application process is relatively straightforward, and you typically need to provide proof of identity, employment and income. Payday lenders generally don’t run a credit check, consider your creditworthiness or factor in your ability to repay the loan.
When you receive your payday loan, the funds are either electronically deposited into your bank account or provided through cash, check or debit card.
For repayment, you generally write a postdated check for the loan balance plus any applicable fees or authorize the payday lender to electronically withdraw the funds from your account. If you don’t repay the loan on or before the due date, the lender can cash the check or withdraw the amount from your account.
What Happens if You Don’t Pay Back a Payday Loan?
Because of their short-term nature, payday loans can be challenging to pay back on time. If you don’t pay back your loan, the payday lender can send your loan to collections or take legal action against you.
You may pay hefty fees for not paying on time, and your credit score can be adversely affected.
Bank Account Debits and Overdrafts
When your payday loan is due, your lender will cash your postdated check or, if you’ve provided the lender with payment authorization, they can electronically access your account to withdraw the amount you owe.
If you don’t have enough money in your account to either cover the check amount or the withdrawal amount, your bank may charge you overdraft fees. The payday lender may try to withdraw smaller amounts rather than the entire amount at one time, and each attempt may incur an overdraft fee from your bank if you don’t have sufficient funds. The lender may also charge fees for the loan not being paid. These fees can quickly add up.
If you provided account authorization to the payday lender, you can tell your bank to stop payment. Your bank won’t issue any scheduled or future payments to the lender. Be aware, though, that banks usually charge a fee for stop-payment orders. And stopping any automatic payments on your payday loan doesn’t cancel your loan agreement with your lender — you still owe the loan balance.
Collection Calls and Emails
When a payday loan isn’t repaid, lenders may start a collection process to get their money back. Payday lenders may contact you by phone or email about your debt and can also contact the references or relatives you listed on your loan application. Lenders will continue their attempts to contact you, and the multiple calls and notices can further add to the stress of defaulting on your loan.
If their efforts aren’t successful, payday lenders may hire a third-party debt collector to take over the collection process. A collection agency may pursue you more aggressively to get you to repay your loan. Their collection fees can be added to what you already owe.
Impact on Credit Score
When you don’t pay back a payday loan and it goes into debt collection, this collection activity is likely to be reported to the credit bureaus. This can lower your credit score and negatively impact your creditworthiness.
Loan defaults can remain on your credit report for up to seven years, according to the Consumer Financial Protection Bureau. This damage to your credit can make it harder to secure financing in the future. And if you do manage to obtain financing, your lower credit score will likely result in much higher interest rates.
Legal Actions and Lawsuits
Once your payday loan has gone into debt collection, your lender or debt collector may sue you to collect your debt, even if it’s a small amount. If the lawsuit is successful, the court will issue a judgment against you for the amount you owe.
This money judgment allows the payday lender or debt collector to pursue further methods to collect the money and fees you owe. The lender or collector can garnish your wages or benefits to pay the debt or place liens on your property.
If you have a money judgment against you and ignore an order to appear in court, a judge may issue an arrest warrant. Never ignore a court order and appear in court when necessary. You may want to get legal advice or consult with an attorney in this situation.
How To Repay a Payday Loan
Because payday loans are so short-term, it may be difficult to repay the loan in full when it’s due. Lenders may offer a few options for repayment, including rolling over your payment or extending your repayment plan.
Make the Full Payment on the Due Date
The best option for repaying a payday loan is to pay back the loan on its due date for the full amount, including any interest or fees. You can return to a payday storefront lender to repay the loan in person, or the money can be electronically debited from your bank account if you’ve provided authorization.
Make sure that you have enough money in your account to cover the loan and any associated fees so you can pay on time without incurring additional costs. Read your loan agreement carefully to understand how your loan will be repaid and what the total cost of the loan may be.
Extended Repayment Plans
If you can’t fully repay your payday loan on time, you can ask your lender if they offer an extended repayment plan. This payment plan allows you to repay your loan in smaller amounts over a longer period. Ask if there’s a cost to the extended repayment plan — your payday lender may offer you a plan for free, or they may charge additional fees.
If an extended repayment plan isn’t available for your loan and you’re struggling to pay it off, look into other resources in your area that may be able to help, like a credit counselor or legal aid.
Roll it Over
If you cannot pay back your loan at its due date, most lenders give you the option to roll over, or renew, the loan. In that circ*mstance, you buy yourself extra time at the cost of more fees.
For example, let’s say you borrow $300. Your original amount to pay back the lender would be $345 (borrowed amount plus a $45 fee). If you roll over the loan, you would simply pay $45 in new fees and in two weeks (or whatever the term amount is) you would pay the rest.
Doing this buys you time, but it increases the overall amount you have borrowed and is a way to get caught in a cycle of debt. Rolling over in no way reduces the principal amount you borrowed, or any earlier fees you might have incurred. Because this is a common way people get into trouble with payday loans, we don’t recommend going this route.
Escaping the Payday Loan Cycle
It may be hard not to rely on payday loans when you’re struggling to make ends meet, and you may become trapped in a cycle of debt. You can take some steps to try to escape the payday loan cycle, like budgeting and building savings to avoid payday loans or seeking alternative financial assistance.
Budgeting and Financial Planning
Financial planning and budgeting can help you take control of your money. If you can cut your spending, you can use that money to pay bills or add to savings. A budget can also help you plan for expensive events like holidays and vacations.
You can create a basic budget by gathering your bills, receipts and pay stubs. Make a note of any extra expenses you may have. Write down how much you spend and how much money you make. Subtract your expenses from your income — if the number is less than zero, you are spending more money than you make. Look over your budget and see where you can spend less.
Emergency Funds and Savings
Choosing one of the best savings accounts and creating an emergency fund can help you escape a payday loan cycle. Savings and emergency funds help you pay for unexpected bills or life events. You can start with a small goal of $500 and save $10 or $20 from every paycheck. If your paycheck is directly deposited into your bank account, you can ask your employer to put a portion into a savings account.
When you have savings and an emergency fund, you may find peace of mind with the knowledge that you are better equipped to handle the expenses of everyday life.
Seeking Alternative Financial Assistance
If you find yourself struggling financially, look into other alternatives before taking out a payday loan. You can ask your creditor for more time to make your payments or ask family and friends to borrow money. You can also see if your local churches or charities offer any assistance for financial hardship.
Additionally, explore other loan options with your local credit unions or banks. Credit unions and banks may offer smaller loans or lines of credit with lower interest rates, meaning you will pay less. They may also provide longer or more flexible repayment terms than payday loans. Loans through credit unions or banks can be much safer and more affordable.
How To Rebuild Credit After Defaulting
When you can’t pay back a payday loan, the damage to your credit can seem insurmountable. While rebuilding your credit after a loan default is difficult, it’s not impossible. With careful monitoring of your credit report and using credit wisely, you can work to rebuild your credit.
Review and Monitor Your Credit Report
You can request your credit report from the three nationwide credit bureaus: Equifax, Experian and Transunion. Each credit bureau is required to provide you with a free report every 12 months. Review your credit report and credit history. Note the number and type of accounts you have, if there are any late payments, your outstanding debt and any collection actions in your credit history.
If there are any inaccuracies, it’s important to dispute them — you don’t want your credit negatively impacted by something incorrect in your credit history. The credit bureaus and the businesses that gave the credit information are responsible for correcting inaccuracies in your report.
Practice Responsible Credit Behavior
You can improve your credit by using your credit wisely and making payments on time. Pay your bills when they’re due, carry lower balances, pay off your credit card debt and try not to take on new debt. When you use credit responsibly, you can start to rebuild your credit.
Consider also speaking with a credit counselor or organization to help you get on the path to good credit.
The Bottom Line
Payday loans can offer quick cash when you’re tight on funds, but the nature of these loans can make it difficult to repay them when they’re due. If you don’t pay back a payday loan, you may face a variety of consequences including increasing your debt, damaging your credit and possibly facing legal action. Be mindful of your loan terms, know how you plan to repay the loan and learn how much in total the loan may cost so you can avoid defaulting.
It may be difficult to break a payday loan cycle, but it’s possible if you take control of your financial situation. Get on track through budgeting, saving and building good credit. Reach out to resources in your community for payday loan alternatives if you’re struggling. Arming yourself with knowledge and options can help you escape a cycle of debt and move toward a better financial future.
Frequently Asked Questions About Payday Loans
According to the Consumer Financial Protection Bureau (CFPB), four out of five loan borrowers don’t pay back their payday loans and renew their loans within two weeks. Over the course of one year, four out of five loan borrowers either default or renew their payday loan; 20% default on a loan at some point.
While it’s not easy to escape a payday loan cycle of accumulating debt, it can be done through repaying your debts on time, budgeting your money and building savings, even if it’s a little bit at a time. Monitor your credit report and take the necessary steps to rebuild your creditworthiness.
Most payday lenders don’t run a credit check when you borrow money. They also don’t generally report information about your loan or borrowing history to the credit bureaus. However, if you default on your payday loan and the debt goes into collections, this can be reported to the credit bureaus and damage your credit score.
If you close your bank account to stop paying back a payday loan, the payday lender can still attempt to cash your postdated check or electronically withdraw money from your account. When these attempts are unsuccessful because your account is closed, the fees and finance charges will start to add up. If you stop payment on a loan, you’ll default and the loan could go into debt collection, which may hurt your credit.
Editor’s Note: Before making significant financial decisions, consider reviewing your options with someoneyou trust, such as a financial adviser, credit counselor or financial professional, since every person’s situation and needs are different.
Diana HoblerContributor
Diana Hobler is a writer and editor, covering finance and fintech for the last two decades. She loves tackling complex financial concepts and making finance accessible to all. When she’s not writing or editing, you can find her managing her lively household of three boys, or staying active and chasing endorphins through a long run or a tough workout. You’ll probably also catch her, more often than not, unwinding with a bowl of ice cream and binge-watching her favorite shows at the end of the day.
Jen Hubley LuckwaldtEditor
Jen Hubley Luckwaldt is an editor and writer with a focus on personal finance and careers. A small business owner for over a decade, Jen helps publications and brands make financial content accessible to readers. Through her clients, Jen’s writing has been syndicated to CNBC, Insider, Yahoo Finance, and many local newspapers. She is a regular contributor to Career Tool Belt and Career Cloud.
