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What is Payday Loan and How it Works?

Last Updated : 02 Jan, 2024
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A payday loan is a short-term loan generally associated with high interest and is typically due on the borrower’s next payday. Here, payday means the day on which an employee receives compensation for the work performed by them during the specified pay period. These loans are also known as cash advances, paycheck advances, or payday advances. Payday loans are often looked at by individuals who need urgent access to funds to cover unexpected expenses and this is a reason why payday loans are offered at higher interest rates. The principal amount of the loan depends on the income of the borrower. The amount offered for a loan is usually equal to a part of an upcoming paycheck of the borrower.

Geeky Takeaways:

  • A payday loan is a high-cost, short-term loan taken by a borrower to meet emergencies or uncertain expenses.
  • The principal amount of the loan depends on the amount of the upcoming paycheck of the borrower.
  • A payday loan is offered by financial institutions known as Payday Lenders.
  • A payday loan is highly risky and an individual shall carefully review the terms and conditions, including the interest rates and fees associated with the loan.

How Payday Loans Work?

A system of payday loans is quite simple and quick. The working of payday loans can be understood below:

1. Application: Payday loans are usually applied online, at storefronts, or through mobile apps. The application process is quick and easy. However, some basic personal information of the borrower like proof of income, employment, and identification is required.

2. Approval and Verification: Lenders approve the application after verifying factors like income, employment status, and the ability to repay. Some lenders may also perform a minimal credit check and may check the credit history of the borrower.

3. Loan Amount Determination: The principal amount of the loan is determined by the lender based on the income of the borrower which is generally a percentage of the borrower’s regular income or a fixed amount. However, in some cases, borrowers may be limited to a certain maximum loan amount.

4. Loan Agreement: After application approval and amount determination, the borrower receives the terms of the loan agreement, including the loan amount, fees, and the due date. Borrowers are often required to provide a post-dated check for the full loan amount or grant electronic access to their bank account for repayment.

5. Fees and Interest Rates: Payday loans are associated with high fees and interest rates. The fees are usually fixed in nature and charged according to the amount of the loan. The rate of interest on payday loans is often very high making them a costly source of credit.

6. Repayment: The payday loan is due on the borrower’s upcoming payday, which lies generally within a few weeks. If the borrower fails to repay the loan fully on the due date, the option to roll over the loan by paying additional fees is exhibited. This can lead to a debt trap as fees accumulate with time.

7. Automatic Repayment: The borrower provides the lender with a post-dated cheque for the full loan amount or authorizes the lender to electronically debit the amount from their bank account on the due date.

What do I need for a Payday Loan?

The specific requirements for a payday loan can vary depending on the lender, however, some common items and information required when applying for a payday loan include:

1. Identification: A valid form of identification, such as a driver’s license, passport, or state-issued ID.

2. Proof of Income: The lenders typically demand proof of a regular source of income like recent pay stubs, bank statements, or proof of employment. Some lenders may accept alternative sources of income, such as government benefits or pension statements.

3. Bank Account: An active checking bank account where the loan funds can be deposited and from which repayments can be withdrawn is needed. Some lenders may also accept savings accounts.

4. Contact Information: The lender requires some contact information, including your address, phone number, and email.

5. Social Security Number: The lenders may also ask for a Social Security number as part of the application process. The Social Security Number is a numerical identifier assigned to a citizen of a nation.

6. Age Verification: Verification of age is a part of the application process because only a person whose age is 18 years can apply for a payday loan. Some lenders may require additional age verification.

7. Employment Details: Employment information is required by the lender, including the name, address, and phone number of an employer.

Importance of a Payday Loan

A payday loan is considered important in the field of credit as:

1. Emergency Situations: Payday loans help borrowers meet uncertainties and emergencies without being dependent on others. It serves as a source of easy credit.

2. Accessibility: Payday loans are featured with a simple application process that increases the accessibility of the loan and makes them easily available.

3. Quick Approval: Payday loans have few formalities that require short-approval time, hence payday loans have a quick approval process, allowing borrowers to access funds within a short timeframe.

4. Absence of Collateral Security: Payday loans are provided without any collateral or guarantor. The upcoming paycheck of the borrower is enough for the approval of the loan.

5. Credit History: Payday loans are easily available even to a person with a bad credit score or to a person already having multiple active loans.

How to Get a Payday Loan?

The process of getting a payday loan is quite simple and hassle-free. However to get a payday loan one shall consider the following points:

1. Check Eligibility: The borrower shall check certain eligibility before applying for the loan including:

  • Minimum Age Requirement,i.e. at least 18 years old.
  • Proof of Income and Employment.
  • Valid ID Proof
  • An active Checking Account

2. Searching Suitable Lenders: Analysing reviews and feedback from other borrowers to find reputable lenders with easy accessibility and credibility.

3. Application: The borrower can apply for a payday loan online through the lender’s website or in person at a physical location by filling in accurate information about income, employment, and ID proof in the application form. The borrower should read the terms and conditions as payday loans are highly risky and high-cost credit.

4. Access to Fund: After approval and verification done by the lender, the amount is disbursed into the borrower’s account. However, the amount of the loan along with interest and fee is automatically deducted from a bank account on the date of the next payday.

Payday Loan Interest Rates

Amount of Loan

Starting from ₹199 up to ₹ 20 Lakhs

Rate of Interest

10% to 45% per annum

Overdue Interest Charges

2% of the overdue amount monthly from the date of the amount overdue

How Payday Loans can Affect Your Credit?

Payday loans can hurt the borrower’s credit under certain circumstances:

1. Credit Inquiries: The lender may perform a soft or hard inquiry on a credit report when a person applies for a payday loan. Such inquiries can have a minor negative impact and multiple hard inquiries within a short period may reflect financial distress to future creditors.

2. Credit Reporting: Payday lenders may report repayment behavior to credit bureaus. Repayment of the loan on time may not positively impact credit score, but on being a defaultor if the lender sells debt to a collection agency, it can have a negative impact on credit.

3. Collection Accounts: On being a defaulter, the lender may send a debt to a collection agency. Collection accounts hamper the credit score and can remain on a credit report for seven years, even if the debts are paid off later.

4. Credit Score Impact: The high cost associated with payday loans and a debt cycle can make it more difficult to come out of these financial obligations. This can result in a lower credit score over time.

5. Loan Rollovers: A continuous rollover of a payday loan by paying only the fees and not the principal amount, can lead to a cycle of debt. This ongoing financial strain can negatively impact your creditworthiness.

Payday Loan Alternatives

1. ‘Bad Credit’ Personal Loan: A type of personal loan available for people with bad credit scores. Such loans do not require security but only a credit check.

2. Credit Union or Community Bank Loans: Some credit unions and community banks offer small loans at low-interest rates to their members under favorable conditions.

3. Negotiating with Creditors: Contacting creditors directly to negotiate payment plans or seeking financial assistance from local charities and nonprofits can be alternatives to payday loans.

4. Financial Counseling: Seeking advice from financial counseling services can help individuals explore alternatives and develop a sustainable financial plan.

5. Loans from Family or Friends: Lending money from close one is another alternative to a payday loan. This further reduces the burden of interest or deadline.

6. Peer-to-peer Loans: Peer-to-peer (P2P) lending is a financial platform that connects borrowers directly with individual lenders or groups of lenders through websites. the best part of this source of credit is that the interest rates are negotiable.

Frequently Asked Questions (FAQs)

1. What is a payday loan?


A payday loan is a short-term, high-cost credit that offers quick access to funds.

2. What are the terms of a payday loan?


Payday loans often have short terms, usually two weeks to a month, or up to the date of the next payday.

3. What are the eligibility criteria for payday loans?


A borrower shall be at least 18 years old and shall have proof of income, valid ID proof, and an active checking bank account.

4. Can I roll over or extend a payday loan?


Yes, on default of repayment payday loans can be extended but are liable to additional fees and interest that can lead to a cycle of debt.

5. Are payday loans regulated?


Payday loans are subject to regulations that vary by regional jurisdiction.

6. Can I get a payday loan if I have bad credit?


Yes, you can avail of payday loan with bad credit based on income proof.

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