If you don’t have a credit card or savings to use in a financial emergency, taking out a payday loan online or in person might seem like a great way to get cash quickly. But payday loans, in states that permit them, have few pros and one big con—the cost.
Before you apply for one, you should fully understand how payday loans work, as well as how expensive and risky these loans are. You might think twice about getting this kind of loan in the first place.
What Is a Payday Loan?
A "payday loan" is a short-term loan that typically comes due on your next payday or the next time you receive income from some other steady source, like Social Security. The loan comes from a payday loan company or online vendor, not a bank.
The loan amount is relatively small, generally $500 or less. In fact, many states have laws that limit the amount you can borrow.
Where Can I Get a Payday Loan?
One way to get a payday loan is to go to a vendor in person and give the lender a post-dated check. (Post-dating a check refers to writing a check but putting a future date on the check instead of the date you sign it.) In return, you receive a sum less than the amount listed on the check. Say you write a check for $500 to the lender. You might get $440 in cash, with the lender keeping $60 as a fee. The lender then waits a few weeks, typically until your payday, and cashes the check once your account has enough money to cover the $500 check.
Another kind of payday loan starts with you signing an agreement giving the lender the right to take money out of your bank account or prepaid card account on your payday to pay back the debt. After you sign, the lender electronically deposits the loan money directly to your account. In our $500 example, the lender deposits $440 in the account and keeps $60 as its fee. In this kind of arrangement, the lender takes the repayment money directly out of the account on your next payday or other date listed in the agreement.
You can also get a payday loan over the phone or online.
Why People Take Out This Kind of Loan
Millions of consumers don’t have access to more traditional banking products. And, even if you have bad credit, it’s relatively easy to qualify for a payday loan.
Often, lenders will make loans online to individuals with bad credit without running a credit check. The most important factor that a lender will consider when deciding whether to make a payday loan is how much you earn.
What Is Needed For a Payday Loan
To get a payday loan, you typically have to provide proof of your income, such as two recent pay stubs. Payday lenders also ordinarily require that you:
- be at least 18 years old
- have an active bank account or prepaid card account
- have an active phone number
- show valid government-issued photo identification (like a driver’s license), and
- provide a Social Security number or Individual Taxpayer Identification number.
State Laws Governing Payday Loans
To reduce payday lending abuses, some state laws limit the amount a lender can charge for a payday loan. Other states have gone as far as making payday lending altogether illegal.
Federal Payday Lending Rule
In 2017, the Consumer Financial Protection Bureau (CFPB) issued a new rule called the "Payday Lending Rule" concerning payday loans. The rule had two major parts: an underwriting part and a part concerning payments.
Underwriting provisions. The underwriting provisions of the Payday Lending Rule prohibited lenders from making covered payday loans without conducting a “full-payment test” or “ability-to-pay test.” But the CFPB eventually eliminated the requirement that lenders confirm borrowers could afford their payday loans from the rule.
Payment provisions. The payment provisions of the Payday Lending Rule limited a lender's ability to obtain loan repayments through preauthorized account access. The rule included a “debit attempt cutoff” for certain payday loans. Under the rule, after two unsuccessful attempts to debit the borrower's account, the lender couldn't debit the account again unless the borrower provided a new authorization. The lender would also have to give consumers written notice before attempting to debit an account at an irregular interval or amount. The CFPB kept these restrictions, which prohibited payday lenders from repeatedly trying to withdraw payments from borrowers' bank accounts. But the provisions didn't go into effect; they went on hold because of a court order.
Community Financial Services of America v. Consumer Financial Protection Bureau
In the case of Community Financial Services of America v. Consumer Financial Protection Bureau, the Court of Appeals for the Fifth Circuit noted that the CFPB gets its funding directly from the Federal Reserve rather than from the usual congressional appropriations process. The court then ruled that this funding mechanism is unconstitutional because it violated the appropriations clause and the Constitution's structural separation of powers.
With this ruling, what was left of the Payday Lending Rule was invalidated, basically as a byproduct of the CFPB's potentially unconstitutional funding scheme. The CFPB appealed this decision to the U.S. Supreme Court.
U.S. Supreme Court Upholds CFPB Funding Structure
On May 16, 2024, the Supreme Court released its decision. (See Consumer Financial Protection Bureau v. Community Financial Services Association of America, Ltd., No. 22-448.)
By a vote of 7-2, the justices reversed the Fifth Circuit’s ruling. The Supreme Court held that Congress’ statutory authorization allowing the CFPB to draw money from the earnings of the Federal Reserve System to carry out the bureau’s duties (12 U.S.C. §§ 5497(a)(1),(2)) satisfies the appropriations clause and doesn't violate separation of powers principles.
So, this ruling clears the way for the CFPB to enforce the Payday Lending Rule. In its current form, the rule restricts lenders’ ability to collect loan payments through preauthorized account access after two unsuccessful withdrawal attempts.
The Cons of Payday Loans
The fees on a payday loan are usually based on increments of the amount borrowed. Lenders often charge a fee of between $10 and $30 for every $100 of the loan amount. These incremental charges make payday loans a very expensive way to borrow money. Generally, the annual percentage rate (APR) on payday loans ranges from 200% to 500%. The APR on a two-week payday loan that has a $15 fee per $100 borrowed is around 400%.
If you can’t repay payday loan debt when it comes due, you might be able to "roll over" the loan. Paying a fee to delay repayment of a payday loan is generally called "rolling" it over. Of course, the drawback to delaying repayment on the loan is that you’ll have to pay another fee to the lender, potentially leading to a treadmill of debt.
Potential Treadmill of Debt
People who take out payday loans often get onto a treadmill of debt, taking out one payday loan after another to cover accumulated fees. According to the Consumer Financial Protection Bureau, around 70% of people who take out a payday loan end up getting an additional loan within 30 days, and 20% of new payday loan borrowers take out ten or more payday loans in a row.
For example, let’s say you took out a $300 payday loan for a $45 fee but can’t pay it back on the due date. To extend the due date, you must pay another $45 fee. Now, you're paying a cost of $90 for the $300 loan. If you roll the loan over again, you have to pay $45 for the third time. The loan has now cost you $135, which is almost half of the original loan amount.
The bottom line is that, in most cases, it's best to avoid payday loans altogether. Better and safer options are available for getting your hands on cash quickly.
Avoiding Payday Loans
Instead of getting a payday loan, you might consider some alternatives, like:
- getting an advance or an emergency loan from an employer, nonprofit organization, or community group
- if you have an account at a bank or credit union, you might qualify for a cheaper loan, especially if you have good credit, or
- working out a deal with a creditor or debt collector to reduce a debt or bill you owe.
Is a Pawnshop a Good Alternative to a Payday Loan?
Pawnbrokers have been serving as a resource for cash-strapped people hoping to sell an item or put up valuable property in exchange for a short-term loan for thousands of years. The process of pawning property for fast cash starts when a customer brings an item into the shop.
Before agreeing to work with you, the broker must determine whether it wants your item. The broker will take into account the property’s resale value, whether there’s much demand for it, and, if you want a loan, how likely it is that you’ll pay off the loan and reclaim the property.
How Pawnshops Make Money
Once the shop decides it wants your item, the shop can profit from the property in different ways, such as by:
- charging interest on a short-term loan secured by the item (collateral)
- selling the collateral if you fail to repay the loan, or
- selling the item it purchased from you outright.
If the broker agrees to give you a short-term loan, you’ll leave the item with the pawnbroker as security for a specified period. In exchange, you’ll get your loan proceeds and a claim ticket that you may use to redeem the item. It’s important to keep the ticket in a safe place because sometimes it’s the only proof you’ll have that you’re entitled to the property. If you pay off the loan as agreed, you’ll get the item back. If you don’t repay the loan, the broker will recoup the loaned money by selling your property.
Whether you're selling an item or using it as the basis for a loan, you should expect the pawnbroker to offer a lower price than what you paid for it. Some haggling is expected.
What Types of Property Do Pawnbrokers Accept?
Because a pawnbroker will want to turn around the property fast, you’ll have a better chance of striking a deal if you want to pawn a smaller item that will sell quickly. Belongings that brokers commonly accept include:
- appliances
- jewelry
- collectibles
- coins
- sporting goods
- tools, and
- electronic equipment.
Keep in mind that the broker is unlikely to be interested in items that people don't really want. For instance, if you just moved from a beach town to a mountain region and you want to pawn your surfboard, you might be out of luck. The broker might assume that because you don’t need it, you’ll be unlikely to return to claim it, or, worse yet, no one else will want it either.
The last thing the pawnbroker wants is a valueless item taking up a lot of space in the shop. So, unless the broker knows a local who likes to surf or has a way to liquidate the board online, it’s unlikely that you’ll get a loan or be able to sell it to the pawnshop.
Before Visiting a Pawnshop, Do Your Homework
It's a good idea to do some preliminary research before you start the process of pawning an item. You should:
- Check to see that the pawnshop’s license is current.
- Find out if the pawnshop is a reputable business by checking its status with the Better Business Bureau.
- Research other options, such as getting a loan from your credit union or getting an advance or emergency credit from an employer, nonprofit organization, or community group, to make sure you’re getting the best deal.
Laws That Apply to Pawnshops
Pawnshops must follow specific laws geared to protect you as a consumer, as well as the public as a whole. Some states have laws regulating the amount of interest and the length of loans. Many federal laws also apply to pawnshop transactions, like:
- The Truth in Lending Act, which requires a shop to disclose loan terms.
- The Equal Credit Opportunity Act, which prohibits lending discrimination due to age, gender, race, national origin, color, religious preference, marital status, or receipt of public assistance benefits.
- The Bank Secrecy Act, which requires a lender to report transactions over a certain dollar amount.
- The Patriot Act, which requires lenders to collect information from borrowers to confirm their identity.
- The Military Lending Act, which caps the annual percentage rate at 36% for covered borrowers.
Getting Help
For an explanation of the applicable payday lending or pawnshop laws in your state and information about how to handle your debt, consider contacting a consumer protection lawyer or a debt collection attorney.
Also, beware of scammers trying to collect on fake payday loans.