Payday loans: what are they and how do they work?

If you need a helping hand at the end of the month, you could turn to a payday loan to get you over the line.

But, with steep interest charges and a well-known history of creating debt traps, are payday loans really worth it?

In this article we will cover:

1. What is a payday loan? 
2. How do payday loans work? 
3. Advantages and disadvantages of payday loans
4. What are the alternatives to payday loans? 

What is a payday loan? 

Payday loans are short-term loans that charge very high interest rates, and are usually only used to tide individuals over for a short time. These loans are often referred to as high-cost, short-term credit (HCSTC) as, while they might seem handy and are approved very quickly, the costs of taking out such loans can spiral rapidly.

While in the UK, payday loans can only charge a maximum daily interest rate of 0.8%, the average APR paid on a payday loan is 1250% - far above that of a credit card at 20.7%.  

Due to the quickly accumulating amount of interest people will sometimes need to pay, HCSTC loans are an often-cited example of ‘predatory’ lending.

While four in five of these loans are usually paid off in a month or less, there is a lot of risk attached to these loans and there are cheaper, safer ways of borrowing money. 

How do payday loans work? 

Payday loans aren’t completely unregulated. If you’re looking to take out a loan, it’s vital you shop around; payday lenders must legally publish their rates on at least one price comparison site, so it pays to be diligent.  

You can find payday or emergency loans online or in stores, and before being given the loan, the lender should ensure that you have the means to repay.

You should be informed how to repay the loan, what a continuous payment authority (CPA) is and by when you will need to repay the loan too.  

Once you have been given the loan, you will then be charged a daily interest rate which will continue until you repay the loan.

The primary method that lenders will look for repayment is through a CPA, which will look to extract payment from the account details you have given. In other words, you give the lender permission to take payment, usually within a month. Your lender shouldn’t attempt to take payment more than twice and should not seek part payment using this method.  

Advantages and disadvantages of payday loans 

Ultimately, payday loans serve the important purpose of providing emergency credit to people who unexpectedly need it. While there are risks, four in five payday loans are repaid within a month. So, who are payday loans for and what are the advantages and disadvantages of these loans? 

Advantages of payday loans

One of the primary advantages of payday loans is the speed and accessibility they offer. There are far fewer obstacles to jump over when you ask to borrow money in this way. And, as they are designed to be repaid when your next salary payment arrives, your repayment will be taken automatically at the same time.

This means that a payday loan simply pays forward your next salary payment – you may hear HCSTC loans called ‘cash advances’ for that very reason. 

You also don’t need to have a good credit score to get a payday loan. Whereas for many existing loans you will need a good credit score, you only need to be able to prove you have the short-term means to repay payday loans to be eligible – no credit score required.

However, while you don’t need a good credit score to apply for a HCSTC loan, it may be impacted as a result. 

Disadvantages of payday loans

While HCSTC loans can be useful if you’re in a pinch, the risks and disadvantages of taking these loans on are well documented.  

Above all, the high charges that come with the loans can lead borrowers to get stuck in a debt trap. According to the Financial Conduct Authority, 67% of payday loan borrowers are over-indebted, when compared with 15% of adults.

The quickly escalating costs mean the longer borrowers go without repaying the due amount, the more the costs can start to spiral, making these extremely risky for people who may not necessarily have the means of repaying, or who simply fall on tough times.  

As mentioned above, don’t be surprised if taking out a payday loan affects your credit score. Different companies, credit reference agencies and borrowers calculate your credit score differently, meaning that even if you repay 100% of the amount on time, some companies might still see you negatively.

On the other hand, some lenders might not differentiate between any of the loans you make, as sometimes needing some extra money at short notice doesn’t mean you aren’t a trustworthy borrower.

However, there always remains the chance that not repaying your loans, or potentially even taking one out, can be viewed negatively. 

What are the alternatives to payday loans? 

There are alternatives to payday loans that are less risky and are less likely to land you in a debt trap. If you’re already in debt, aren’t sure you can repay a payday loan or simply want to find another way to source finance, consider looking elsewhere.  

Debt consolidation 

Borrowing money is normal for individuals and businesses who need to find a little extra.

But when you have outstanding debts, with variable rates and different repayment dates, it might be time to consolidate. Debt consolidation, or refinancing, amends all your existing debts into one monthly payment, rendering the process of paying it all off again much easier.  

Extend your overdraft 

If you only need a temporary fix, you might be able to extend your overdraft with your bank. You may have an agreed overdraft threshold which may allow you to turn around your outstanding debt within a reasonable period. But even if you don’t, the daily fees of an overdraft are typically less than those of a payday lender. 

Seek out a credit union 

Credit unions are co-operatively run organisations that look to make cheap credit available to people who need it. Unions are there to help members save and borrow and will usually offer a payday loan of some kind, but with reduced interest rates.

The maximum interest rate credit unions can charge is capped and only reserved for the shortest loans, if at all. 

Budget and save 

You may not even need to borrow at all. 61% of payday borrowers don’t feel confident managing their money, so there’s little use taking on debts if you aren’t going to be able to repay it in the future.

It isn’t always possible to budget for everything we’d like, but by adopting some key principles, you can certainly plan ahead and save for whatever comes, avoiding the use of additional borrowing altogether. 

Plan your finances 

A financial adviser can help you plan for the future. Whatever your financial goals are, taking on the right financial guidance can help steer you away from borrowing, keeping your finances in the black.

Find an expert financial adviser near you on Unbiased.   

If you found this article useful, you might also find our articles on what buy now pay later is and how it works and what is a financial coach informative, too!