What Is a Payday Loan?

Sometimes, pay day feels like the farthest day away. Luckily, there's a lending solution to cover your immediate bills and financial needs until your next paycheck. These loans are called payday loans: short-term cash loans in which payment is due typically due within two weeks—or close to your next payday. In fact, The Economist estimates that roughly 2.5 million American households take out payday loans each year. However, how do you know if these generally smaller loans are right for you?

Asking yourself a series of questions before applying for any loan is the right way to make this decision. Often, the reason why people opt for payday loans is to make it to their next paycheck. This can be anything from utility expenses to an unforeseen medical expense. Typically, payday loans are $500 or under, depending on your state of residency. Colleen McCreary, chief people officer at Credit Karma shared exactly what a payday loan is, how you apply for one, and is this type of loan a good idea.

How Do Payday Loans Work?

What's the approval process like? McCreary says, "A payday loan typically works like this: If approved, you either write a post-dated check or sign an automatic withdrawal authorization form that lets the lender take the money due (principal, interest, and fees) from your bank account after the date of your next expected paycheck." She adds that, "even though you may be required to leave a post-dated check at the store, many payday loan lenders will require you to return on your payday to pay the balance off."

The Downside

What happens if you can't pay the payday loan off by your next paycheck? According to McCreary, a few things can occur. "If you can't repay the loan after your next paycheck, the lender might offer to let you roll your current loan over into a new one," she says. "This includes the existing loan and fees—on top of the new loan amount and fees—so that now you have an even larger loan to pay off on your next payday."

McCreary warns that payday loans, while they may seem small, come with high fees as well as high-interest rates. Because payday loans have such short repayment terms, these costs translate to a steep APR. According to the Consumer Federation of America, payday loan APRs are usually 400 percent or more. In other words, borrowers can find themselves in more debt after the fact. "If you can't repay yours right away, you may find yourself refinancing the debt repeatedly and paying more in interest than the original amount you borrowed," says McCreary. This is why some states prohibit payday loans altogether.

Instead of opting for a payday loan, McCreary says to consider other alternatives first: asking for an extension, seek a payday alternative loan, or a small personal loan. To avoid getting into the situation where a payday loan is the only option, McCreary suggests paying bills on time, pay down debt, don't close old credit cards, don't open too many credit lines at the same time, and diversify your credit mix.