If you must borrow, borrow safely.

By Lauren Phillips
July 08, 2020

When money is in short supply, it’s hard to know where to turn. Borrowing money from family is a popular option, but not one everyone can rely on. During the coronavirus crisis, the U.S. CARES Act made it possible to withdraw or borrow money from your 401k retirement savings, but doing so comes with its own consequences—and is only possible for those with retirement savings already. The same is true for an emergency fund: Turning to one now is only possible for those who were able to build one before times got tough.

For people who need money quickly—either because they’ve lost income and need money to cover essentials or because they face an unexpected expense—there are borrowing options, including personal loans and payday loans. (Other quick ways of getting cash include selling belongings, taking out title loans on cars, and taking other actions that put personal possessions in jeopardy.)

Unfortunately, federal regulations to protect borrowers against predatory payday loans are weak: as The New York Times reports, the Consumer Financial Protection Bureau just ended a plan to put new limits on payday lending that would have saved borrowers about $7 billion each year in fees. The rules would have limited how many loans borrowers could take in a row and required lenders to check that borrowers had the means to repay their debt; with the rollback of new regulations, it is as easy as ever to get caught in a cycle of payday loan debt.

Payday loans are widely advertised—and there’s even a new set of trendy, upbeat apps that offer what are essentially payday loans—but few people understand how they function, even as they consider taking out a payday loan. Before you agree to a payday loan, make sure you understand the terms and do your research, otherwise you could find yourself in an even deeper money pit.

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What is a payday loan, and how do payday loans work?

A payday loan is a small, short-term, high-rate loan. Payday loans work this way: A borrower writes a check payable to the lender for the amount the person wants to borrow, plus the fee for borrowing. The lender gives the borrower the agreed upon amount of money and keeps the check until the loan is due—typically on the borrower’s next payday, hence the name. The lender then deposits the check, getting back the money they lent plus the fee. The borrower will have the amount of money they borrowed taken straight from their bank account.

Payday loans are also sometimes called cash advance loans, check advance loans, post-dated check loans, or deferred deposit loans, according to the Federal Trade Commission (FTC), the U.S. consumer protection agency. The requirements for getting a payday loan are typically only an open bank account in good standing, a steady source of income, and some form of ID—no credit check. Payday loans tend to be a couple hundred dollars—some states even have maximum limits for payday loans—and have a term of around two weeks, or one payday cycle.

In theory, payday loans are a simple way to get money quickly without a hard credit check, making them seem like a good option for people with bad or no credit. In practice, they tend to be predatory and land many people in deep debt: The risk lies in the details, namely, the interest rate and fees.

“Payday loans can help cover the immediate need of unexpected expenses,” says Lauren Wybar, CFP, a senior financial advisor at Vanguard Personal Advisor Services. “However, these loans almost always have extremely high interest rates and fees. They are rarely a good financial decision and should only be considered as a last resort.”

How payday loans get people in deeper debt

There’s nothing wrong with borrowing money or taking out loans—having well-managed debt is actually an important part of practicing financial wellness. Payday loans are notoriously difficult to manage, though, because they have very high fees and interest rates and are marketed toward people already living paycheck to paycheck who will likely have a difficult time repaying the debt in full.

According to the FTC, payday loan fees can be a percentage of the amount borrowed or a flat-fee based on the increments of money borrowed. For a $100 loan, for example, the fee could be $15, with an additional $15 for every $100 borrowed. The fee is re-charged with every loan renewal or roll-over if the borrower is unable to repay the loan within the set time period—again, typically two weeks. Payday loans will also have an annual percentage rate (APR), which is based on many factors and further adds to the amount owed.

For those living paycheck to paycheck, repaying payday loans is particularly challenging because repaying one loan with a paycheck means not having enough money left to make it to the next paycheck. In that situation, another payday loan is often taken out, with the same fees and APR; once you get into that cycle—repaying a payday loan only to take out another loan to make it to the next paycheck—it’s difficult to stop.

The regular fees, short payment periods, and small payment amounts mean the cost of taking out a payday loan adds up very quickly, says Nancy DeRusso, SVP and head of coaching at Ayco, a Goldman Sachs company that provides employer-sponsored financial advising. “It’s a short-term solution,” she says.

Should you take out a payday loan?

Experts agree that payday loans should be approached cautiously. They may solve a short-term money crunch, but if you’re unable to pay back the initial loan with money left over to avoid taking out another one, they can get you in even bigger trouble.

Still, financial sense doesn’t outweigh the urgency many people feel when they’re unable to purchase essentials or pay their bills. If you must borrow money and are unable to responsibly borrow from family or friends, first research short-term alternatives to a payday loan. The FTC suggests a small loan from your credit union or bank or a small loan company—be sure to pay attention to the fine print to understand any associated fees and interest rates to ensure this is a smarter option than a payday loan.

If a payday loan is still the only option (as it is for many), shop around for the loan with the lowest fees and interest rates. (Lenders are required by law to disclose the cost of the loan.) Borrow only what you must, and make it less than your paycheck, so you can repay the loan without incurring extra fees—ideally with enough money left over to make it to your next paycheck, so you don’t have to borrow more money to fill the gap.

While you’re researching loan options—regardless of your credit or income—be wary of apps that promise to loan money quickly. Many offer small cash loans within a few days and often have no credit check, and they say they’re safer, smarter alternatives to payday loans.

Many of these apps do function as payday loans, even if they have lower fees or interest rates. “It’s kind of like they’re going behind the guise of these apps and making it seem like it’s not a payday loan,” says Andrea Koryn Williams, CFP, CLU, ChFC, a wealth management advisor with Northwestern Mutual. As with traditional payday loans, research fees and costs associated with the service.

Once you’re past the current financial crunch that has forced you to seek out a short-term loan, focus on being proactive: Learn how to budget money so you’re living within your means and don’t need to borrow money to make it to the next paycheck. At the very least, get in the habit of paying attention to how much money you spend and how much you earn to understand how much you need to set aside to cover the essentials. Learning how to save money can help with penny-pinching and finding extra money over the long-term and borrowing money (when done responsibly) can cover unexpected expenses, but nothing replaces the solid financial footing a budget provides.