How Do Payday Loans Work?

Like any other cash advance, a payday loan is a contract between a borrower and a lender. In exchange for a specific amount of money from the lender today, the borrower agrees to repay the amount borrowed plus an agreed-upon amount of interest or fees by a specific date in the future. Most payday loans function similarly to balloon loans, meaning the full balance of the debenture is due in one payment.

The name payday loan signifies the original type of advance where a borrower would borrow money that was needed before they received their next paycheck. Traditionally, the borrower would write a postdated check for the borrower’s next payday. The amount of the check would cover the principal of the payday loan, with interest rates and any fees. For example, a customer might borrow $200 on the 7th when they get paid on the 15th. The lender would give the borrower $200. The borrower would give the lender a check for $220 dated for the 15th of the month.

These days, payday loans come in many different forms, including those where no postdated check is required.

Who Offers Payday Loans?

Typically, payday loans are not offered by traditional lenders such as banks and credit unions. Instead, payday loans are offered by small businesses such as check cashing businesses, pawn shops, and payday loan companies.

How to Use a Payday Loan

Payday loans should be used for short-term borrowing. The purpose of a payday loan is to offer an easy way to get cash quickly that can be paid back soon. Good uses of payday loans are for unexpected emergency expenses or to pay bills or other obligations when they are due instead of dealing with the problems of a late payment. If you must choose between being charged a $50 late fee and having a late payment reported on your credit or paying $30 to borrow money for a few days, it’s better to borrow the money.

Although many payday loans are not tied to the borrower’s payday, the best use of these loans always involves knowing exactly how and when the cash advance will be paid back. In other words, you should have a payday loan repayment plan before you borrow the money.

Features of a Payday Loan

A payday loan is usually an unsecured advance. However, some payday lenders, especially pawn shops, may offer lower interest rates for payday loans secured by property left in the lender’s possession. In addition, some lenders will accept the title to the borrower’s car as collateral. These are known as title loans.

Some states have a maximum payday loan size with $500 to $1,000 being the average. Some states also limit the overall interest and fees charged on a payday loan to between $10 per $100 and $30 per $100. 

Payday Loan Interest Rates

One common criticism of payday loans is the high interest rates. While annual percentage rates can be as high as 400% or more, payday loans are designed to be small, short-term advances with no credit checks and no delays of having to open and maintain an account like a credit card. Although the annual rate may be high as a percentage, the overall dollar amounts are smaller because of the short debenture period. A $200 loan might cost as little as $20, that’s just a 10% payday loan interest rate. That is because the loan is only for one month, and not a full annual period.

Paying Back a Payday Loan

Usually the borrower is supposed to return to pay off the cash advance. However, if the borrower does not return, the lender can cash the postdated check or debit the account electronically to collect the required repayment. If the account has insufficient funds, then the lender may charge an additional NSF, or non-sufficient funds, charge in addition to the amount already owed.

Online Payday Loans

A recent advance in the payday loan industry is online payday loans. With an online payday loan, instead of the lender providing cash and the borrower writing a check, the borrower simply links a checking account to the payday lender. The lender sends the advance proceeds via an ACH (automated clearing house) deposit transfer directly into the borrower’s account. When the loan period is up, the lender automatically initiates an ACH withdrawal, which pulls the payday loan repayment plus interest directly from the account.

With an online payday loan, the application, loan, and repayment happens entirely online. The borrower may never meet the lender in person.

Military Lending Act

The Military Lending Act (MLA) is a federal law that applies to all 50 U.S. states. The MLA caps interest rates at 36%. That amount applies to certain fees on many types of loans, including payday loans for active-duty service members, active Guard members, active Reserve members, and their qualifying dependents. 

Renewing or Rolling Over a Payday Loan

Payday loans are designed to be paid in full at the end of the short loan period. However, sometimes a borrower might need longer to repay the advance. In that case, the payday lender may let the borrower renew or roll over the loan.

In the case that payday loan renewal is necessary, the borrower pays the interest fees on the cash advance. The original loan terms, including interest owed, stay the same and the loan becomes due on a later date. This has the effect of paying the interest twice.

Some states have outlawed the ability to get a payday loan renewal. However, in those states, many borrowers get around the limitation by taking out a new payday loan with a different lender to repay the original advance. Assuming the new lender charges the same interest rate, then the net result is the same as renewing the loan.

Payday Loan Repayment Plan

A repayment plan on payday loans allows the borrower to make smaller, ongoing payments to pay off the original payday loan. An arrangement must be made with the lender to allow such a repayment plan. Repayment plans on payday loans are legally required in some states when the debentures meet certain conditions.

To learn more about how payday loans work, including interest rates, repayment plans, and renewal options, or to apply for a cash advance, contact EZ Money today.