Why is a payday loan a bad idea?

You’ve probably heard of payday loans, even if you’ve never gotten one. And good for you if you haven’t heard of payday loans because they are a really bad idea.

Let’s put it this way: they’re one of those financial arrangements that’s incredibly easy to get into, but painfully difficult to get out of.

Let’s unpack what payday loans are, how they work, and why you should always look for alternatives to this type of loan.

A payday loan is a very short-term loan. Short-term as in no more than a few weeks. They’re usually available through payday lenders operating out of storefronts, but some are now also operating online.

Payday loans work best for people who need cash in a hurry. That’s because the entire application process can be completed in a matter of minutes — literally.

Payday lenders will verify your income and that you have a bank checking account. The income check is to determine your ability to repay, while the bank account check is to confirm how you will pay.

When your loan is approved, the funds are deposited into the verified bank account. But even more important, the lender will require that you write a postdated check in payment of both the loan amount and the interest charged on it.

For example, let’s say that you’re granted a $500 loan on October 16, at 400% APR. (And yes, 400% APR is pretty standard for payday loans.) Since the loan will require repayment within two weeks, you will write a check back to the lender that’s dated for October 30. The check will be for $575: $500 for their loan repayment, plus $75 for two weeks’ interest.

The postdated check ensures that the lender will be paid back by the scheduled date and that they won’t have to chase you to get it. Borrowers tolerate the postdated check arrangement because the other major component that lenders normally look at — namely, credit history — is ignored by payday lenders.

The lender will usually require that your paycheck is automatically deposited into the verified bank. The postdated check will then be set to coincide with the payroll deposit, ensuring that the post-dated check will clear the account.

That’s why they’re called “payday loans.”

People with poor credit are natural clientele for payday loans. The borrower can apply for the loan, and not be at all concerned if their credit is either ugly or nonexistent.

People with little or no savings represent another natural market. A 2022 Lending Club report found that 64% of Americans are living payheck to paycheck.

And a 2022 survey by Bankrate found that 56% of Americans would be unable to cover an unexpected $1,000 bill with their savings.

Add to that current inflation rates and post-pandemic financial struggles, and you can see the enormous potential market for payday loans, and why they’re so stubbornly popular.

Since bad credit and a lack of savings often go hand-in-hand, payday lenders have a built-in market. And while many people can still get by day-to-day without having any savings, an emergency situation creates a need for immediate cash.

For example, say you have bad credit, no savings, and car trouble. You find out that it will cost $700 to fix your vehicle. You need the car to get to work, and since you have no available credit and no savings, you turn to payday lenders. You may have no idea how to come up with $700 (plus interest) in two weeks, but the loan buys you some time.

According to Pew Charitable Trusts, 12 million Americans take out payday loans each year, spending $9 billion on loan fees. Meanwhile, federal lawmakers are working to reduce payday loan rates from 400% to 36%.

Payday loans are often used in place of emergency savings accounts, although many people, unfortunately, also use them for regular living expenses.

The most obvious problem with payday loans is the cost. We just did an example of a borrower who pays $75 in interest for a $500 loan. If that was the cost of interest for a full year, the interest rate would be 15%. That would be a decent rate for someone who has either bad credit or no credit, and is taking an unsecured loan.

But the $75 is the interest charged for just two weeks. And what makes it even more concerning is the fact that this interest rate is being charged to the people who can least afford it. If a person doesn’t have $500 today, they probably won’t be any more likely to have $575 in two weeks. But that’s what they’ll have to come up with.

And that’s why it gets worse.

People who take payday loans often get locked into an ongoing cycle. One payday loan creates the need for a second, which creates the need for a third, and so on.

The problem is that the borrower usually needs to take another payday loan to pay off the first one. The whole reason for taking the first payday loan was that they didn’t have the money for an emergency. Since regular earnings will be consumed by regular expenses, they won’t be any better off in two weeks.

The lender might provide continuous financing by rolling over the loan every two weeks. The borrower will have to pay the interest every two weeks, but the original loan balance will remain outstanding.

Because the borrower will have to pay $75 every two weeks, he’ll end up paying $1,950 in interest over a year, in order to gain the one-time benefit of the $500 loan.

This is another reason why payday loans rarely exceed $1,000. The payday lenders are keenly aware that the likelihood of being repaid declines with the size of the loan.

And should you be unable to make good on your payday loan, lenders are among the most savage when it comes to collecting. You will not only be hounded by collection calls and threats, but you almost certainly will be slapped with a court judgment.

While payday loans can seem like the only option in an emergency, that’s far from true. Even those with poorer credit scores can qualify for fast funding. Before jumping to a payday loan, consider one of these options first:

Personal loans

• Estimated APRs: Varies by credit score, but the average is 11.73%
• Other fees: Origination fees, often around 2% of the loan
• Amount you can borrow: Small or large amounts often up to about $100,000

A personal loan is exactly what it sounds like: a loan you can use for any personal use. There are very few limitations for a personal loan, and there are even lenders that exist specifically to help those with poor credit.

Even the best personal loans can come with some fairly high interest rates in the double digits, and some even come with origination fees, so make sure you take these into account when asking for a specific loan amount. Online lenders often have fast-turnaround times for these loans, with some even offering next-day funding.

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Cash advances

• Estimated APRs: N/A
• Other fees: Subscription fees from cash advance apps
• Amount you can borrow: Usually only a few hundred dollars

Cash advances are a very short-term solution, and they operate almost like a payday loan but without the ridiculous fees. When you use a cash advance app, you’re taking out a small loan and you’ll automatically repay that loan when you get paid next.

These loans are often a few hundred dollars at most and the fees associated with them are often subscription fees from the app. You likely won’t even pay interest, assuming you can pay back the loan quickly. There are even some banks that offer cash advances through your checking and/or savings account.

Low-interest credit cards

• Estimated APRs: Varies by credit, but 16%-24% is common
• Other fees: Late fees, if payments aren’t made on time
• Amount you can borrow: Up to your personal credit limit

Credit cards often have high interest rates, but they’re nothing like a payday loan’s interest rates. If you have a low APR on your credit card, consider using that in an emergency. It’s already at your disposal and even if you can’t pay back the balance right away, you won’t be paying over 100% in interest.

Plus, some of these cards come with cash back, which can be redeemed for statement credits, helping you pay down the balance. Just ensure that with the new purchase(s) you’re putting on your card, you can still make the monthly minimum payment.

Peer-to-peer loans

• Estimated APRs: About 6%-35%, depending on your credit score
• Other fees: Origination fees, often of around 3% of the loan
• Amount you can borrow: Small or large amounts often up to about $100,000

Peer-to-peer lending popped up in the early 2010s and, as their name suggests, these loans are offered through companies that get investors to invest in your loan. Peer-to-peer loans can come in fairly large amounts and some offer relatively low interest rates. It all depends on your credit score.

Many of these companies provide funding within a few days, but be aware of the credit limitations. Since companies that offer peer-to-peer loans are using everyday investors to fund your loan, they often have stricter credit requirements.

Home equity loans

• Estimated APRs: ~ 7%, on average
• Other fees: Closing costs ranging from 2%-5% of the loan amount
• Amount you can borrow: Often up to 80% of your home’s equity

Home equity loans draw on the equity you have in your home and turn it into a loan. This option should be above payday loans, but still a last resort. Your home acts as collateral, so if you can’t make payments any longer, the lender could seize your home. Still, HELOC loans are good options for any emergency that happens within your home.

These loans don’t come with super-low interest rates but again, they’re much better than payday loans. This funding won’t happen as quickly as some of the other options above, and you won’t get the full amount of your equity. Most lenders can only offer you a loan of up to 80% of your home equity value.

There’s no shame in reaching a point where a payday loan seems like the only option. Many borrowers don’t have the best of credit for a variety of reasons, and in an emergency, you need money quickly.

Still, payday loans are best avoided at all costs, so make sure that next time you need to borrow money, you don’t need to rely on these hazardous loans.

Take the following steps to ensure you can avoid needing a payday loan in the future:

• Set aside small amounts of money as often as you can — You don’t need to put aside $100+ every time. Even just $10 here and there builds up. Every time you have a few dollars, move it to your savings accounts, or go the old-fashioned way and store it in a savings jar. You can even save automatically using spare change apps that move very small amounts of money into a savings account for you. This money can act as an emergency fund, and you should only touch it when there’s a true emergency.
• Take out a credit builder loan now — Credit builder loans are designed to help you build up your credit before you reach a situation where you need a loan. These loans are often microloans of no more than $1,000. You make monthly payments, the lender puts the money aside in a savings account, and when you’re done making payments, you get access to the money. All the while, the lender is reporting your on-time payments to the credit bureaus.
• Have a credit card just for emergencies — Take your lowest-interest credit card and set it aside in a drawer somewhere. This ensures you won’t use it, and it can act as an emergency fund when needed. Plus, nothing is a faster funding option than just pulling out your card from its hiding place.
• Cut back on any expenses you don’t truly need — If you can, cutting back on expenses can free up cash you can put right into your emergency fund. Again, this doesn’t have to be a ton of money. Take the $5/month you spend on a subscription service and save it instead.
• Get credit counseling — If your low credit score is holding you back, take advantage of free credit counseling options. The National Foundation for Credit Counseling can help you find a counselor who can help you sort out your money goals and make a realistic plan to improve your score.

Payday loans are designed to trap you in a cycle of debt. When an emergency hits and you have poor credit and no savings, it may seem like you have no other choice. But choosing a payday loan negatively affects your credit, any savings you could have had, and may even cause you to land you in court.

There are alternatives to payday loans — and good ones. If you need a payday loan, choose one of these other options because getting a loan for 300-500% interest over a few weeks is just never, ever the way to go.