Payday loans: 4 things you need to know

A payday loan provides fast access to cash but the cost can be prohibitive. (iStock)

For millions of Americans living paycheck-to-paycheck, an unexpected expense can be difficult to cope with.

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Payday loans -- small short-term loans designed to assist until your next paycheck arrives -- may seem like the solution. These loans don't typically require a credit check and provide fast access to cash. But the convenience can come at a very steep price.

What is a payday loan?

A payday loan is a short-term loan you're expected to repay within a few weeks of borrowing. Loans may be available from online lenders, through payday loan apps, or from local lenders -- although some states prohibit these types. The amount you can borrow is also usually limited by state law, with many states setting a $500 cap.

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Payday loans seem attractive because they often provide same-day funding regardless of your credit score. As long as you can meet some minimal requirements, such as showing proof of income and an active bank account, you can get a payday loan.

How does a payday loan work?

Unlike many loans, you don't make payments over time with a payday loan. Instead, the entire borrowed amount -- plus fees -- must be repaid in a lump sum payment. Often, you're required to write a post-dated check for the amount due or provide authorization to withdraw the money directly from your bank account.

Fees are often very high, even though many states limit costs. Fees are often capped between $10 to $30 per $100 borrowed. This is significantly higher than the average credit card APR of 15.10 percent reported by the Federal Reserve in 2019.

What are the risks?

Because fees are so high and repayment times so short, many borrowers can't repay payday loans when they come due and must take out a second loan, incurring additional fees. The Consumer Financial Protection Bureau (CPFB) found that more than four of every five payday loans were renewed within the same month. And regulations aimed at preventing this type of re-borrowing are currently being rolled back.

Banking relationships are affected when borrowers can't repay loans, as lenders cash post-dated checks or withdraw funds from bank accounts with insufficient funds. Half of all payday loan borrowers ended up owing bank fees for overdrafts or returned checks within 18 months, incurring an average of $185 in costs. More than a third actually had their accounts closed, according to the CFPB. This makes future financial transactions, such as paying bills or cashing a paycheck, much more difficult and expensive.

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High payday loan costs also increase the chances of default, which means borrowers simply don't repay their loans. One in five borrowers who have taken out repeated payday loans end up defaulting and are often subject to aggressive collection efforts.

What are the alternatives?

Some payday loan alternatives, such as auto title loans, can be even more damaging than payday loans. These require borrowers to use their vehicle as collateral to guarantee a short-term loan similar to a payday loan. The lender can take the car if the borrower can't repay what they owe.

But there are also other, more affordable options that may be available depending on your situation.

If you've been a member of a credit union for at least a month, you may qualify for a payday alternative loan. These offer timely approval, are easy to qualify for, and allow you to borrow between $200 and $1,000 that you can repay over one to six months. Credit unions can charge only the cost of loan processing, with a maximum fee of $20.

Or, if you borrow from friends, family, or your employer, you may be able to avoid loan costs altogether --  although company policy and state laws vary regarding the availability and costs of paycheck advances. And if you have access to a credit card, making a purchase or taking out a cash advance to access funds could be cheaper than a payday loan even though interest charges can still be high, especially for cash advances.

Ultimately, the best option to avoid a payday loan is to save up an emergency fund with several months of living expenses so you can cover unexpected costs without borrowing. While this will take time, it ensures high fees and interest charges don't add to your financial woes when surprise expenses inevitably occur.