What is a payday loan, and how does it work?

You need money quickly, maybe for a utility bill or car repair. You see an ad for a payday loan and wonder if it's the right move.

A payday loan is a small, short-term loan—usually $500 or less—that's typically due on your next payday. While they can be ways to get quick cash, that convenience isn't cheap.

Instead of charging traditional interest, payday lenders charge a flat fee, usually $10 to $30 for every $100 borrowed. On a two-week loan, that fee could work out to an annual percentage rate (APR) of 400% or more.

This guide explains how payday loans work and what a $500 loan could cost. It also covers lower-cost options for a short-term cash need.

What is a payday loan?

Payday loans are exactly what they sound like: short-term loans that are usually due by your next payday. You may hear payday loans referred to as payday advance loans, paycheck loans, cash advances, or check loans. 

Depending on where you live, you could borrow from a storefront lender or online. The lender might give you cash, a check, a direct deposit, or a balance on a prepaid card.

Most payday loans share a few features:

• Small amounts. Many states limit payday loan size, and $500 is a common cap. 

• Short terms. You usually repay the loan in one payment, two to four weeks after you borrow. The due date often falls on your next payday. It could instead fall on the day you receive other income, such as Social Security or a pension.

• Automatic repayment. You may write a post-dated check for the full amount, including fees, or you might need to authorize the lender to withdraw the full amount from your account on your next payday.

• No collateral. Payday loans are generally unsecured loans. You don't pledge property, such as a car, to back the loan.

Some lenders let you repay in installments over a longer period instead of all at once. You might also have the option to extend your loan—for a fee. This could land you in a dangerous debt trap where your fees wind up costing more than your loan.

Some states don't allow payday lending at all. If your state does, your state regulator or attorney general could confirm whether a lender holds a license there.

How do payday loans work, and who qualifies?

Here’s how payday loans tend to work in practice:

1. Apply. You apply at a storefront or online. Lenders typically ask for a valid ID and proof of income. They might also ask for a bank, credit union, or prepaid card account.

2. Authorize repayment. You sign the loan agreement and write a post-dated check or give the lender permission to debit your account. The lender then gives you the funds.

3. Repay on the due date. On the date your agreement sets, the lender cashes your check or withdraws the full balance plus the fee.

4. Roll over, if your state allows it. In a rollover, also called a renewal, you pay only the fee, and the lender moves the due date back. You still owe the full amount you borrowed, plus additional fees.

Payday loan requirements are usually less strict than for other loans. Payday lenders generally don't use your credit reports or credit scores to decide whether to lend to you. 

Some lenders may check specialty credit reporting companies, which collect information about things like your history with bank accounts, payday loans, rent, or utilities. Payday lenders also generally don't check whether you could repay the loan and still cover your other bills.

What happens if you can't repay a payday loan on the due date?

Some state laws require payday lenders to offer an extended repayment plan to borrowers who have trouble repaying. These plans could carry their own fees, so ask what an extension would cost before you agree to one. 

If you don't repay, the lender might send or sell the debt to a debt collector. Some payday lenders and collectors also file lawsuits to collect.

How much does a payday loan cost? A $500 example

Payday lenders typically add a finance charge for every $100 you borrow. Many state laws set a maximum fee, which commonly ranges from $10 to $30 per $100. A fee of $15 per $100 is common.

The annual percentage rate shows what that fee costs on a yearly basis. A payday loan typically lasts only about two weeks. That’s why a fee of $15 per $100 equals such a high APR.

Here’s what a $500 payday loan could cost at two common fee levels:

Illustrative example: Fees and rules vary by state.

CFPB research notes that online payday loans tend to cost more than storefront loans, with fees often reaching as high as $30 per $100. At that level, the fee on a $500 loan would be $150. On a two-week loan, that’s equivalent to a roughly 780% APR. 

In contrast, the highest APR on most credit cards and personal loans is 36%.

Risks of payday loans

The biggest risk of payday loans is the cost—especially how expensive they get if you can't repay:

• Fees can be very high. The full balance plus the fee comes due in about two weeks on a payday loan, which could leave you short before your next paycheck. That might lead you to roll over the loan or take out a new one. 

• Rollovers could cause a debt spiral. If your financial situation doesn't improve, you could find yourself rolling over a payday loan multiple times. Those fees can add up fast.

• Automatic withdrawals could lead to bank fees. If you don't have the money in your account, the lender's withdrawal attempt might fail. That could lead to your bank charging overdraft or insufficient funds fees. Repeated attempts could mean repeated fees.

Active-duty service members and their dependents do have extra protection. The Military Lending Act caps the Military Annual Percentage Rate at 36% on payday and other consumer loans. Service members could also get help from a service relief society or their local Judge Advocate General's (JAG) office.

If you have a problem with a payday lender, you can submit a complaint to the CFPB online or by calling (855) 411-2372.

Alternatives to payday loans

Before you borrow, compare a few lower-cost options:

• Payday alternative loans (PALs). Some federal credit unions offer these small-dollar loans to members. Federal rules cap the application fee and allow longer repayment terms than payday loans. 

• Your bank or credit union. Ask about small lower-cost loans, especially if you have direct deposit or a steady credit history.

• A credit card. A credit card, if you have one, could cost less for a short-term expense.

• More time from creditors. Ask the company you owe for a later due date or a payment plan.

• An employer advance. Some employers offer advances on pay you've already earned.

• Local help. A call to 211 could connect you with local emergency assistance programs.

• Free cash advance apps. These work by advancing you a portion of your wages before payday and deducting that amount from your bank account when your paycheck arrives.

If you're managing several debts, the free Achieve GOOD app can help you track them in one place and build a payoff plan.