What Is a Payday Loan and How Does It Work? - NerdWallet (2024)

What is a payday loan?

A payday loan is a high-cost, short-term loan for a small amount — typically $500 or less — that’s meant to be repaid with the borrower's next paycheck. Payday loans require only proof of identification, income and a bank account and are often made to people who have bad or nonexistent credit.

Financial experts caution against payday loans — particularly if there’s any chance the borrower can't repay the loan — and recommend alternative lending sources instead. (See the alternatives section at the end.)

How do payday loans work?

A payday lender will confirm your income and checking account information and deliver cash then and there at a store. For online transactions, the lender will send funds electronically to your bank account the same or next day.

In exchange, the lender will ask for a signed, post-dated personal check or permission to electronically withdraw money from your bank account on the due date. The loan is due on your next payday, typically in two weeks, but sometimes in one month.

If the loan is issued at a store, you may return before or on the payment due date. If you don’t show up, the lender will repay itself by running the check or withdrawing repayment from your bank account. Online lenders use an electronic withdrawal.

How much do payday loans cost?

Payday loans typically cost $10 to $30 for every $100 borrowed, according to the Consumer Financial Protection Bureau. If you borrow $100, and the fee is $15 for every $100 borrowed, your total repayment will be $115.

If you don’t repay the loan in full on the due date, the lender may add a fee to extend the due date. If this cycle repeats, borrowers can end up owing more in interest than the original loan amount.

That’s why payday loans are risky — it's easy to get trapped in a cycle of debt and expensive to get out.

Payday loans and interest rates: What to know

Payday and other high-cost lenders prefer to explain the cost of borrowing in terms of fees rather than interest. However, payday lenders, like all lenders, must disclose the annual percentage rate the fee equates to before the borrower signs a loan agreement. A $100 payday loan with a $15 fee due in two weeks equates to an APR of 391%.

The APR is the best apples-to-apples cost comparison tool for loans and credit cards. For example, if a credit card has a 15% APR, a personal loan has a 25% APR and a payday loan has a 350% APR, then the credit card is the least expensive option and the payday loan is the most expensive.

What happens if I can't repay a payday loan?

Depending on the lender and the state you live in, the payday lender could charge a late fee or returned payment fee.

Your bank or credit union may charge a nonsufficient funds fee or an overdraft fee if repaying a payday loan causes you to overdraw your account.

How do payday loans affect credit?

Paying back a payday loan doesn't usually build credit. Most payday lenders don’t report on-time payments to credit bureaus, so the loan can't help your credit score.

If you don’t pay the loan back, however, your credit can be damaged. The payday lender may report the default to the credit bureaus or sell the debt to a collections agency that will do so, which will hurt your score.

Are payday loans legal?

Each state has its own payday loan regulations, usually by setting limits on the APR lenders can charge on a small loan, based on the loan’s size and repayment term. Many states have enacted tight restrictions on the cost of consumer loans in the past few years, effectively outlawing payday loans, but they’re not illegal everywhere.

Payday loans and the Military Lending Act

The Military Lending Act (MLA) prevents lenders from providing loans with APRs above 36% to active-duty military members, their spouses or certain dependents.

Here’s who the law covers:

Because of the MLA, payday and other high-cost lenders frequently don’t allow members of the military to apply for a loan.

How to get a payday loan

Payday loan alternatives to consider

Use an interest-free cash advance app. Mobile apps like Earnin, Dave and Brigit can offer interest-free or low-fee advances on your paycheck, though there are eligibility requirements and caps on how much you can borrow.

Get a personal loan from a credit union or online lender. A personal loan will likely carry a lower APR than a payday loan, so it’s more affordable. Credit unions tend to offer the lowest rates for bad-credit applicants, and many offer payday alternative loans, specifically, but you’ll need to become a member before applying. Online lenders also serve bad-credit borrowers and can fund loans the next business day, but rates may be higher.

Borrow money from a family member or friend. A loved one may be able to spot you the funds. This will save you money on interest, and you won’t have to undergo a credit check. Just make sure you agree to the terms of the loan, such as when you’ll pay it back.

Reach out to a community organization. There are local and regional organizations that provide free funds to cover essential expenses. Check NerdWallet’s database of financial assistance programs to see what’s available in your state.

Use a BNPL app to cover a necessary purchase. “Buy now, pay later” apps like Affirm, Afterpay and Klarna can split up your online or in-store purchase into equal installments, often for zero interest and no fees if you pay on time. These apps may be a smart solution for covering an essential expense, like a mattress or toiletries.

You could also consider a credit card cash advance or a pawnshop loan. Though these options should offer lower interest rates than a payday loan, they are still costly.

Once your immediate cash emergency passes, start building an emergency fund. If you can save even a few hundred dollars over time, then you’re repaying yourself rather than a lender when emergencies arise.