(LoanSafe.org) – What is a payday loan? Payday loans are typically small, short-term loans intended to cover a borrower’s expenses until his or her’s next payday. Payday loans vary by lenders, but the majority use the borrower’s next paycheck as collateral while charging an interest and fee for the loan. While the most common name is “payday loans” they can also be referred to as cash advance loans, check advance loans, post-dated check loans, or deferred deposit loans.

As the saying goes, if it seems too good to be true, it probably is. The Federal Trade Commission says that “regardless of their name, these small, short-term, high-rate loans by check cashers, finance companies and others all come at a very high price.” Read on to learn more about payday loans.

Understanding the Payday Advance Market

The payday advance industry became popular during the 1990s by catering to an unfulfilled demand for small, short-term consumer loans, according to a study by the Federal Deposit and Insurance Corporation (FDIC) and Georgetown University’s McDonough School of Business. Payday advances are single payment loans and their underwriting process normally does not involve a credit investigation. Because of the limited amount of documentation and credit required for the loan, it is not uncommon for a payday loan customer to have cash flow difficulties or a poor credit.

The study revealed that payday loan customers typically:

* Use small and short term loans, typically $500 or less, as a bridge to their next paycheck;
* Were recently turned down for other forms of credit or offered less credit than the amount they applied for;
* Have consumer credit problems or a limited credit availability due to a bankruptcy filing in the past five years;
* And/or have been 60 or more days late on a mortgage or consumer debt in the last year.

As a result of these characteristics, payday lending is generally characterized as a form of subprime lending.

How does a payday loan work?

The loan process can vary depending on lenders, but typically a payday loan starts with the borrower writing a personal check payable to a specific lender for the amount the person wants to borrow, plus interest and fees.

For example, in return for the small loan of $500, Joe provides a payday lender with a check or debit authorization for $500, plus interest and a finance charge. The lender agrees to hold the check until the Joe’s next payday. At the next payday, Joe may redeem the check by paying the loan amount plus fees, or the lender may cash the check.

In some cases, a borrower may extend their loan by paying only the finance charge and writing a new check, essentially starting the process over with a new, higher balance.

Why are payday loans controversial?

Payday loans have been controversial over the years for a combination of reasons – questionable collection practices by lenders, high interest rates, and the many disputes occurring over evolving and sometimes complicated credit laws, to name a few. While the adjustable percentage rate (APR) for payday loans varies depending on the lender and how long the check is held before being deposited, expect the rates to be incredibly high.

According to the FDIC, payday loans typically range from $100 to $500, although some states permit payday loans up to $1,000. The finance charge applied to payday loans is typically between $15 and $20 per $100 borrowed and payday loans are often times renewed because the borrower cannot afford to pay off the principle, while also keeping up with the weekly fees they incur.

The bottom line, according to the Federal Trade Commission, is try to find an alternative to the payday loan. If you must use a payday loan, try to limit the amount and borrow only as much as you can afford to pay back with your next paycheck and still have enough to make it to next payday

What are some alternatives to payday loans?

If you’re looking to start a small business, you will want to consider all your financing options, but pay careful attention to the fine print associated with both traditional and nontraditional lending offers. Payday loans are generally not a popular choice for funding a business because the loan amounts are generally small and come at a high interest rate.  The following options are popular alternatives to payday loans.

* Bootstrapping/Personal savings: Entrepreneurs with very limited capital can find start up funds by reaching into their pockets and pinching together a mixture of supplemental income, credit cards, stock investments, revolving lines of credit, and loans.

* Small loan from a credit union or a small loan company: Some banks may offer short-term loans for small amounts at competitive rates. A local community-based organization may make small business loans to entrepreneurs In any case, shop first and compare all available offers.  Read more about credit unions.

* Low-cost credit offers: Compare the APR and the finance charge, which includes loan fees, interest and other credit costs. Military personnel have special protections against super-high fees or rates, and consumers in some states and the District of Columbia have some protections dealing with limits on rates.  A cash advance on a credit card also may be possible, but it may have a higher interest rate than other sources of funds; find out the terms before you decide.

* SBA loans, including the Microloan Program: Although the government does not lend money to small businesses, it does provide guaranties to lenders. Government-backed small business loans provide more security for lenders, making them more likely to approve an application. The Microloan Program is designed to provide small (up to $35,000) loans to as many small businesses as possible. Because of its success, the program just received additional funding through the Recovery Act to continue its efforts.

Moe Bedard
My name is Maurice "Moe" Bedard. I am the founder of America's #1 Mortgage Forum, LoanSafe.org. My online work has been featured in the New York Times, LA Times, Fox Business, and many other media publications.