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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 an income and 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 immediately – and recommend alternative lending sources instead.
How do payday loans work?
A payday lender will confirm your income and checking account information and deliver cash in as little as 15 minutes at a store or, if the transaction is done online, as early as the same day.
In exchange, the lender will ask for a signed check or permission to electronically withdraw money from your bank account. The loan is due immediately after your next payday, typically in two weeks, but sometimes in one month.
If the loan is issued at a store, the lender will make an appointment for you to return when the loan is due. If you don’t show up, the lender will run the check or make the withdrawal for the loan amount plus interest. Online lenders use an electronic withdrawal.
What is a direct payday loan?
Online payday loans may go through a direct payday lender, which makes its own decisions about loans, or a broker, who sells your loan to the highest bidder.
Choosing a lender that uses a broker is riskier because you don’t know who you’re giving your financial information to. Not only is there a greater risk of fraud and unwanted solicitation with a broker, but it can also increase the overall cost of the loan.
The cost of a loan from a payday lender is typically $15 for every $100 borrowed, according to the Consumer Financial Protection Bureau. For a two-week loan, that’s effectively a 391% APR.
If the loan isn’t repaid in full on the first payday, a fee is added and the cycle repeats. Within a few months, borrowers can end up owing more in interest than the original loan amount. According to the Pew Charitable Trusts, borrowers pay an average of $520 in fees to borrow $375.
That’s why payday loans are risky – it’s easy to get trapped in a cycle of debt and expensive to get out.
The amount you can borrow varies according to your state’s laws and your finances. Most states that allow payday lending cap amounts somewhere from $300 to $1,000. Check your state’s payday lending statutes .
This doesn’t mean you’ll be approved for the highest amount allowed by law. A payday lender may consider your income when deciding how much you can borrow. However, other payday lenders may not evaluate your ability to repay, or your other obligations, leaving you at risk for financially overextending yourself.
Does paying back payday loans build 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.