"If you would know the value of money, go and try to borrow some." 

—Benjamin Franklin

Introduction

Well over 400 years ago, Shakespeare wrote Hamlet. From this play, a famous line emerged: "Neither a borrower nor a lender be." But today, borrowing and lending are very common. In fact, as many as 80 percent of American consumers owe some type of debt.¹ This may be for long-term loans, such as home mortgages, vehicle loans, or student loans, or for revolving credit, such as credit cards. It could even be for payday loans. 

Storefront payday loan businesses began to spring up across the country in the 1980s.² In 2017, there were 14,348 payday loan storefronts³ in the United States. This was about the same number of Starbucks locations⁴ and slightly more than the 14,027 McDonald's locations in that same year.⁵ The industry expanded in the 1990s when the internet added the convenience of online payday lending. 

What Are Payday Loans?

Payday loans are a type of alternative financial service. The loans provide fast cash to cover emergency situations or help pay a borrower's expenses from one paycheck to the next. Most loans are for $500 or less.⁶ They are called "payday loans" because the length of a loan usually matches the borrower's payday schedule. The length could be for one week, two weeks, or a month, depending on how often the borrower is paid or receives income. A balloon payment—full amount of the loan plus fees—is generally due on the borrower's next payday after the loan is made. 

Payday loans can be taken out at storefront locations that provide face-to-face contact with lenders. Or the loans can be made online. Both work the same, except there's no face-to-face contact with lenders for online loans. In this case, the borrower applies for the loan online and gives the lender access to their checking account electronically. The lender can then make a  direct deposit of the money borrowed into a borrower's checking account and withdraw the payment on the due date directly from the account.⁷

Securing Payday Loans 

Credit reports and credit scores are not required for payday loans, so getting a payday loan is fairly easy.⁸ To obtain a payday loan, borrowers must have⁹ 

• a bank (or credit union) account or a prepaid card account;
• proof of income from a job or some source;
• valid identification; and
• proof of age—must be at least 18 years old.

Payment Plan Options

For storefront loans, a borrower is generally required to provide a postdated check. In this case, a check is written for the full amount borrowed plus fees and interest for the loan. The payday lender agrees to hold the check until the loan is due—the borrower's next payday. If the borrower does not return to the storefront to make other arrangements to pay or renew the loan, the lender can cash the check. The borrower's account must have enough funds to cover the check to avoid having a bounced check and an overdraft. The overdraft will trigger an additional fee charged to the borrower's account, and the loan will remain unpaid. This can lead to the lender placing the debt in collection and suing the borrower. 

Another payment option, especially with online loans, requires the borrower to give the lender access to his or her bank or credit union account electronically. On the loan's due date, the lender can electronically deduct the full amount directly from the account.¹⁰ This allows the lender to be paid ahead of the borrower's other bills and expenses. If the borrower makes arrangements to renew the loan, only the additional fees are withdrawn. The borrower's account must have enough funds to cover the withdrawal to avoid an overdraft. In some cases, payday lenders can offer longer-term payday installment loans.With installment loans, lenders are authorized to electronically withdraw multiple payments from a borrower's bank account, typically due on each pay date.¹¹ 

Loans can also be secured using a prepaid debit card. When using a prepaid debit card, the amount of the loan is deposited directly on the card and the borrower gives the lender the right to electronically deduct the full amount from their prepaid card when the payment is due. Prepaid card usage is more common among unbanked households, especially in lower-income households, less-educated households, younger households, and some minority households (Figure).¹² Unbanked borrowers, as the word implies, do not have a bank or credit union account at all. Underbanked consumers have a bank account but also use alternative financial services, such as payday loans.

Know the Cost

Payday loans cost far more than traditional loans because of fees. Collectively, borrowers spend as much as $9 billion each year on payday loan fees. On average, the fee for a payday loan is $55 for a two-week loan, and the typical $375 loan will incur $520 in fees because of repeat borrowing.¹³ But the federal Truth in Lending Act makes sure borrowers have the facts about the cost of borrowing. This law requires lenders to disclose the cost of a payday loan before a borrower enters into a loan agreement. The cost must be disclosed in terms of the finance charge (fee) and also as an annual percentage rate (APR).¹⁴ With this knowledge, borrowers can compare the cost of a payday loan with other types of borrowing. To calculate the APR, the interest and fees for the amount borrowed are compared with what the amount would be for a one-year period (see "Calculating the APR of a Payday Loan").

Who Uses Payday Loans

As many as 12 million Americans use payday loans each year.¹⁵ Payday loans are marketed as a convenient, short-term solution when a borrower needs cash for unexpected or emergency expenses. However, 7 of 10 borrowers use the loans for basic expenses such as rent and utilities. This comes as no surprise since as many as 58 percent of borrowers have problems meeting basic monthly expenses.¹⁶ 

Payday lenders study their market and locate storefronts in areas where people are more likely to use payday loans. For example, payday storefronts are more likely to be located in areas with higher-than-average poverty rates, lower income levels, more single parents, and with some minority groups. Also, on average, payday loan borrowers have low education levels.¹⁷ 

Payday loans fulfill a need for many people, especially consumers who don't have access to traditional loans or who have no or low credit scores.¹⁸ In 2017, estimates show that among U.S. households, 6.5 percent (8.4 million) were unbanked; and 18.7 percent (24.2 million) were underbanked—that is, they had a bank account but used alternative financial services, such as payday loans.¹⁹ With bad credit (no or low credit scores), these consumers are often unable to get traditional loans, so they turn to alternative lenders. 

State Regulation 

In the United States, the authority to regulate payday lenders is given to individual states. Each state has its own laws to regulate payday lending, which can complicate things. Seventeen states and the District of Columbia either prohibit payday lending entirely or have set interest rate caps that make it difficult for lenders to earn enough profit.²⁰ The remaining 33 states permit payday lending. These states have either exempted payday loans from usury laws or chosen to not regulate the interest rates on the loans.²¹ 

The different regulations among states mean payday loans are structured and priced very differently. Practices within states address concerns such as repeat borrowing, cooling-off (waiting) periods between loans, loan limits, loan lengths, renewal restrictions, and effective APR caps.²² And some states require payday loans to have installment payments rather than the traditional single balloon payment.²³ Among states that permit payday lending, there is a wide variation in the cost of borrowing. Within a given state, lenders charge similar fees set at or near the maximum allowed by law (see "Sample of U.S. Payday Loan Interest Rates Calculated for a Typical Payday Loan").

Federal Regulation

Payday loans are commonly used by consumers in the military. In 2017, about 44 percent of service members received a payday loan. This compares with only 7 percent of all consumers using these loans. To protect active duty service members from high interest rates and fees, the Military Lending Act was passed. This federal law prohibits payday lenders from charging active duty military members more than 36 percent interest on many loan products, including payday loans.²⁴  

To help protect all consumers, the Consumer Financial Protection Bureau (CFPB) was created in 2011.²⁵ Among other things, the CFPB examines evidence and evaluates payday lending practices. It works with state and federal regulators to enforce the law and look for ways to improve the access, quality, and cost of credit for consumers.²⁶

Conclusion

Payday loans provide fast cash—immediately or at least within 24 hours from requesting the loan. They are convenient, and for some consumers they can be the only available loan source. Looking into payday lending—the structure, the high fees, the high rates of renewal and loan sequences, the cycle of debt—provides reason for concern. Because of this concern, many states prohibit payday loans, while others heavily regulate them. As with all forms of credit, borrowers need to be aware of the facts and avoid taking on debt they cannot afford. 

Notes

¹ Horton, Melissa. "Payday Loan Statistics." LendEDU. September 28, 2018; https://lendedu.com/blog/payday-loan-statistics/.

² Lulic, Miron. "History of Payday Loans." October 13, 2014; https://www.loannow.com/history-payday-loans/.

³ Consumer Financial Protection Bureau. "Consumer Financial Protection Bureau Releases Notices of Proposed Rulemaking on Payday Lending; Payday, Vehicle Title, and Certain High-Cost Installment Loans." February 2019; https://files.consumerfinance.gov/f/documents/cfpb_payday_nprm-2019-reconsideration.pdf.

⁴ Cowley, Stacy. "Consumer Protection Bureau Cripples New Rules for Payday Loans." New York Times. February 6, 2019; https://www.nytimes.com/2019/02/06/business/payday-loans-rules-cfpb.html.

⁵ Statista. "Number of McDonald's Restaurants in North America from 2012 to 2017, by Country"; https://www.statista.com/statistics/256040/mcdonalds-restaurants-in-north-america/.

⁶ Consumer Financial Protection Bureau. "Payday Loans." 2017; https://www.consumerfinance.gov/ask-cfpb/what-is-a-payday-loan-en-1567/.

⁷ Consumer Financial Protection Bureau. "Payday Loans and Deposit Advance Products: A White Paper of Initial Data Findings." April 24, 2013b; http://files.consumerfinance.gov/f/201304_cfpb_payday-dap-whitepaper.pdf.

⁸ Consumer Federation of America, "Payday Loan Consumer Information." 2015; https://paydayloaninfo.org/.

⁹ Consumer Financial Protection Bureau. "Payday Loans." 2017; https://www.consumerfinance.gov/ask-cfpb/what-do-i-need-to-qualify-for-a-payday-loan-en-1593/.

¹⁰ Consumer Financial Protection Bureau. "Payday Loans." 2017; https://www.consumerfinance.gov/ask-cfpb/how-do-i-repay-a-payday-loan-en-1599/.

¹¹ Consumer Federation of America, 2015.

¹² Federal Deposit Insurance Corporation. "FDIC National Survey of Unbanked and Underbanked Households." October 2018; https://www.fdic.gov/householdsurvey/2017/2017execsumm.pdf.

¹³ Pew Charitable Trusts. "Payday Loan Facts and the CFPB's Impact: FACT SHEET." January 14, 2016; https://www.pewtrusts.org/en/research-and-analysis/fact-sheets/2016/01/payday-loan-facts-and-the-cfpbs-impact.

¹⁴ Fox, Jean Ann. "The Growth of Legal Loan Sharking: A Report on the Payday Loan Industry." Consumer Federation of America, 1998; https://consumerfed.org/pdfs/The_Growth_of_Legal_Loan_Sharking_1998.pdf.

¹⁵ Pew Charitable Trusts, 2016.

¹⁶ Pew Charitable Trusts, 2016.

¹⁷ Mahon, Joe. "Tracking Fringe Banking." Federal Reserve Bank of Minneapolis Fedgazette, September 2008; https://www.minneapolisfed.org/publications/fedgazette/tracking-fringe-banking.

¹⁸ Bonsai Finance. "Payday Loan with a Prepaid Debit Card: How to Get a Loan When You Only Have a Debit Card." June 2018; https://bonsaifinance.com/payday-loan-with-a-prepaid-debit-card-how-get-loan-when-only-have-debit-card-lc/.

¹⁹ Federal Deposit Insurance Corporation. "2017 FDIC National Survey of Unbanked and Underbanked Households." October 2018; https://www.fdic.gov/householdsurvey/.

²⁰ Consumer Financial Protection Bureau, 2019.

²¹ Consumer Financial Protection Bureau, 2019.

²² Burke, Kathleen; Lanning, Jonathan; Leary, Jesse and Wang, Jialan. "CFPB Data Point: Payday Lending." CFPB Office of Research, March 2014; http://files.consumerfinance.gov/f/201403_cfpb_report_payday-lending.pdf. 

²³ Montezemolo, Susanna. "Payday Lending Abuses and Predatory Practices: The State of Lending in America & Its Impact on U.S. Households." Center for Responsible Learning, September 2013; http://www.responsiblelending.org/state-of-lending/reports/10-Payday-Loans.pdf.

²⁴ Sandbert, Erica. "Everything You Need to Know About Payday Loans." U.S. News & World Report, October 2018; https://loans.usnews.com/everything-you-need-to-know-about-payday-loans.

²⁵ Simon, Helen. "The Motley Fool; What Is the Consumer Financial Protection Bureau, and How Can It Help You?" December 12, 2015; https://www.fool.com/investing/general/2015/12/12/what-is-the-consumer-financial-protection-bureau-a.aspx.

²⁶ Consumer Financial Protection Bureau. "Consumer Financial Protection Bureau Releases Notices of Proposed Rulemaking on Payday Lending" February 06, 2019; https://www.consumerfinance.gov/about-us/newsroom/consumer-financial-protection-bureau-releases-notices-proposed-rulemaking-payday-lending/.

© 2019, Federal Reserve Bank of St. Louis. The views expressed are those of the author(s) and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

Glossary

Alternative financial services: Financial services offered by providers that are not banks.

Annual percentage rate (APR): The percentage cost of credit on an annual basis and the total cost of credit to the consumer.

Bounced check: A check that is written from a checking account, submitted for payment, and returned because the account does not have enough funds to cover the amount of the check.

Checking account: An account held at a bank or credit union in which account owners deposit funds. 

Cooling-off period: An interval of time during which no action of a specific type can be taken.

Credit score: A number based on information in a credit report, which indicates a person's credit risk.

Interest: The price of using someone else's money. 

Interest rate: The percentage of the amount of a loan that is charged for a loan. Also, the percentage paid on a savings account.

Overdraft: The result of an account holder authorizing a withdrawal through a check, ATM withdrawal, debit card purchase, or electronic payment when the account does not have enough money to cover the transaction.

Revolving credit: A line of available credit that is usually designed to be used repeatedly, with a preapproved credit limit. The amount of available credit decreases and increases as funds are borrowed and then repaid with interest.

Usury law: Consumer protection law that regulates the amount of interest charged on a loan by setting caps on the maximum amount of interest that can be charged.