What Is A Payday Loan?
A payday loan is a short-term loan that the lender shall supply to a borrower at high interest. The amount for these loans may equal a borrower’s monthly income or next paycheck. Thus, in case of a lack of finances arising between payment cycles, it provides immediate credit or funds.
A payday loan does not require collateral; thus, it is unsecured lending for the lender. As a result, the lender will charge the borrower a predatory interest rate as an incentive for guaranteed returns. Although, it is risky lending for the lenders as they do not consider the ability of the borrower to repay the loan.
Table of contents
- Payday loan is a short-term, high-interest incurring loan that a borrower may avail due to cashflow shortage.
- An individual or business may be able to borrow a same-day payday loan, even with a poor credit score and no collateral.
- Although there are various states in the U.S, such as New York, Connecticut, New Jersey, etc., that have banned or eliminated such predatory lending.
- The states are regulating them because of the rising inability of borrowers to repay such high-interest loans.
How Does A Payday Loan Work?
A payday loan refers to the need for urgent and temporary credit or funds required by an individual or business. The lender who provides credit charges a high interest to facilitate this collateral-free loan. Additionally, the payday loan direct lender shall charge excessively high fees in case of faltering or late payments; otherwise, there is no assurance that the lender to recover their funds.
Such a loan may be risk-taking for borrowers due to high-interest rates and hidden charges, which may require them to take another loan later to repay the first one. Thus, it is also known as predatory lending. There is also little guarantee for the lender to recover the entire amount with interest. Again, it is because of the lack of collateral and information about the borrower’s credit history and ability to repay.
Although a payday loan term is usually 30 days or less, which defines the gap between the two paychecks of an individual or business looking to borrow for such a short term, the loan amount may range from $100 to $100,000. Thus, while determining the principal amount for lending, the lender will refer to the borrower’s monthly income. Usually, a payday loan direct lender will lend a proportion of this monthly income with high-interest charges.
Short-term loans are extremely helpful for micro, small, and medium-sized businesses as they may often face a cash flow shortage to make immediate payments or run operations. Thus, a same-day payday loan is easier to acquire for such businesses even without a good or excellent credit score. Additionally, a lender takes lesser time to underwrite and facilitate this short-term loan enabling the borrower to access needed funds quickly.
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To process a payday loan, a lender may require the following details and information about the borrower,
- Payslip of the borrower to determine the principal amount of the loan as it works as proof of the borrower’s income.
- Payday loan lenders do not check the borrower’s credit score or lend without strictly demanding an excellent or good credit score.
- A lender might use the borrower’s monthly wages as collateral.
- To process the loan, the lender might charge the borrower additional fees, such as overhead costs, late payment fees, etc.
- The loan comes with a shorter repayment period when compared to long-term loans.
The extremely high-interest rates on payday loans have become a matter of concern for borrowers. The predatory nature of payday loans in the U.S charge an average interest rate between 391% to 600% as an annual percentage rate. Although, these interest charges may increase for different states in the U.S. as per the usury laws and regulations.
For instance, 16 states in the U.S have banned payday loan provisions due to the rising inability of borrowers to repay the loans. According to statistics released by the U.S government agency – the Consumer Financial Protection Bureau says that almost 80% of loans do not get paid back in two weeks which leads to an increase in the debt amount due to soaring interest.
Consequently, a borrower might have to avail of additional loans to repay consolidated payday loans. Thus, in 2021 certain states in the U.S took measures to stamp out or clamp down on high payday loan interest rates. These included Minnesota, Indiana, Tennessee, Virginia, and Illinois.
Although, the cumulative interest a borrower pays might be less when compared to long-term loans, which may extend up to 25 years. These loans also help certain businesses remain stable as the repayment period is short, eliminating the obligation of accruing interest.
Consolidation is a method to manage the payday loans of a borrower who might be struggling to pay off multiple short-term loans. It allows a borrower to combine multiple existing loans under a new loan, such as a personal loan which might be available at a low-interest rate.
It helps a borrower to escape the high and multiplying interest rate of payday loans. Consequently, it prevents an excessive increase in the total amount a borrower owes and turns it into a low-interest accruing loan type. Additionally, the borrower gets some breathing space by extending the repayment period and reducing the sum of monthly installments.
Thus, a borrower may apply for a personal loan at a credit union, bank, or online lender. Simultaneously, the borrower can pay off their existing high-interest loans after receiving the lump sum loan amount. In addition, personal loans have a maximum annual percentage rate (APR) of 36%, making monthly loan installments comparatively lower.
Suppose John runs a garments business and has continuous vendor payment cycles with cloth and elastic suppliers, dyes and chemicals suppliers, sewing yarn thread sellers, designers and fabric testers, etc. Thus, his business must keep all payments clear, so the supply chain moves unhindered.
For instance, John receives a bulk order from a warehouse and retail business that wishes to sell his products. Thus, to complete such an order, John might have to avail of an advance payday loan to fulfill the order and meet the urgent cash flow demand. Although it will be a short-term loan that he can repay in a few months, it will also generate high interest.
However, for his business type, the opportunity cost of letting go of a bulk order would have been higher than the interest incurred on a short-term loan.
Payday Loan vs Personal Loan
Let us compare the two types of loans to understand which loan is more beneficial for a borrower and also a lender while we also consider their cons,
|Payday Loan||Personal Loan|
|It is a short-term loan that a borrower may avail to compensate for a sudden cashflow shortage until they receive their next paycheck.||A personal loan is an installment loan, a long-term loan, as their repayment may extend up to 7 years. These loans assist an individual or business in incurring any capital expenditures.|
|Availing instant payday loan is easier and faster to process even when an individual or entity has a poor credit score from lenders other than banks or credit unions.||However, in the case of a personal loan, the credit score of an individual or organization is extremely important. Additionally, these loans take longer to process.|
|These loans do not require the borrower to give collateral or a down payment.||It requires collateral or an asset as an assurance for the lender. Additionally, there are overhead costs involved in processing these loans.|
|These loans have a very high-interest rate and accruing penalties.||Comparatively, these loans have lower interest and late payment charges.|
|The borrower has to repay the entire loan amount, i.e., principal and interest, in one single go.||A personal loan has the option of repayment in installments and has lower monthly installments.|
Frequently Asked Questions (FAQs)
These loans are easily available today through online and offline platforms. Additionally, lenders usually do not check a borrower’s credit scores before lending.
Cashflow shortage or requirement for urgent funds can occur in any business and individual in case they have lower savings. Although before applying for a payday loan, one should evaluate the opportunity costs and gains of availing such a loan as these attract high-interest rates with short repayment periods.
It is a rather simple process:
1. One should look for a suitable lender, i.e., terms and conditions such as interest rate, repayment timeline, etc.
2. After ensuring such details, the borrower shall fill out the form and wait for a response from the lender.
3. If the loan is approved, the agreement provided by the lender should be read thoroughly before e-signing it.
This article has been a guide to Payday Loan. A guide to Payday Loan. Here we explain its working, requirements, interest rates, example and compare it with personal loan. You can also go through our recommended articles on corporate finance –