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Payday loans are a type of short-term, high-cost cash advance designed to help borrowers cover expenses until their next paycheck. These loans typically involve providing a lender with a post-dated check or access to your bank account, which the lender then cashes on your next payday. While they offer quick access to funds, understanding their history, costs, and potential risks is crucial for anyone considering this financial product.

What Are Payday Loans and How Did They Evolve?

The concept of payday lending has roots in the "salary buying" trade of the early 20th century. In that era, salary purchasers would advance money at high fees, secured by a wage assignment. If the loan wasn't repaid, the purchaser could threaten to inform the borrower's employer, potentially leading to job termination (Calder 1999).

Today, a post-dated check or direct debit authorization has replaced the wage assignment as the primary guarantee for a payday loan. To obtain one, customers typically need an open checking account and a stable source of income, such as a paycheck, pension, or W-2 wages. The application process is often quick and convenient, with many lenders using systems like Teletrack to assess risk in this subprime credit market segment.

Payday loans first emerged in the Southern United States in the late 1980s and saw rapid growth throughout the 1990s (Illinois OFI 2000). For example, the first retail payday loan store opened in Wisconsin in 1993, and by 2003, there were approximately 400 licensed services in the state. Payday lenders often concentrate in urban areas, particularly in neighborhoods with fewer traditional bank branches (Graves 2003).

How Do Payday Loans Work and What Do They Cost?

Payday loans are designed to be repaid quickly, usually within two weeks, coinciding with the borrower's next payday. Historically, a common charge for a two-week payday loan was $20 for every $100 borrowed. When calculated as an Annual Percentage Rate (APR), the interest charges on such loans can be extremely high, with reports from 2001 indicating rates that could exceed 500% (CFA 2001).

While industry representatives often argue that interpreting these fees as an APR is misleading because the loans are intended to be short-term, studies have shown that many payday loan clients frequently "rollover" or renew their loans. This means they pay multiple fees for a single cash advance, indicating that the loans are often not truly short-term in practice.

What Are the Risks and Common Practices?

The practice of rolling over loans is widespread and contributes significantly to the high cost of payday lending. Several studies highlight this trend:

• A 1999 report by the Indiana Department of Financial Institutions (DFI) found that 91% of clients in that state rolled over their loans, with an average of ten renewals (Indiana DFI 1999).
• An industry-funded study reported that 75% of a national sample renewed their loans at least once, and over 40% renewed them five or more times (Elliehausen & Lawrence 2001).
• According to a 2001 report from the Wisconsin DFI, just over half of the loans it assessed were rolled over, with 38% of clients renewing their loans more than three times (Wisconsin DFI 2001).

Reports suggest that a significant portion of the income and profits for payday lenders comes from this "churning" or repeated lending (Stegman & Faris 2003; Ernst, Farris & King 2004).

Beyond rollovers, some borrowers resort to taking out multiple payday loans simultaneously. The industry-funded study mentioned earlier found that one-third of payday credit clients reported using the advance from one loan to pay off another loan at a different outlet. Anecdotal evidence also suggests debtors borrowing multiple times against the same paycheck. State reports indicate that the typical payday loan customer might take out a dozen loans a year, and not all of these are repaid in an orderly fashion.

For instance, a team of researchers in Ohio observed one individual approved for nine loans in three days, even though lenders supposedly used the Teletrack system to assess risk (Johnson 2002). This practice of accumulating multiple loans can lead to severe financial distress, with many individuals ultimately filing for bankruptcy due to debts owed to various payday lenders.

Who Typically Uses Payday Loans?

Payday loan customers are disproportionately likely to have filed for bankruptcy in the past, being four times more prone to do so than the average adult (Elliehausen & Lawrence 2001). These clients often belong to demographics more vulnerable to financial hardship, including working, lower, and middle-income populations (Sullivan, Warren & Westbrook 2000).

Studies consistently paint a similar profile of the typical payday loan borrower:

• In a Wisconsin OFI study, the average gross yearly earnings of these borrowers was approximately $25,000.
• The majority did not own their homes.
• A significant portion were women.
• According to the Illinois OFI, the characteristic payday loan client is a woman in her mid-30s with gross monthly earnings of about $2,000.
• Fast cash debtors are more likely to be separated, single parents, or divorced (Elliehausen & Lawrence 2001).
• Another study found that Black individuals are twice as likely as White individuals to have used this product (Stegman & Faris 2003).

By definition, payday loans fall into the subprime lending category, a market segment known for its higher rates of bankruptcy. Examining bankruptcy filings provides insight into the financial challenges faced by a subset of payday loan clients.

Frequently Asked Questions

What is a payday loan?

A payday loan is a short-term cash advance designed to cover expenses until your next paycheck. It typically requires an open checking account and a stable income, with repayment due on your next payday.

How much do payday loans typically cost?

Historically, a common charge for a two-week payday loan was $20 for every $100 borrowed. When converted to an Annual Percentage Rate (APR), these charges can be very high, with some reports from 2001 indicating rates exceeding 500%.

Are payday loans often renewed?

Yes, studies consistently show high rates of loan rollovers or renewals. For example, a 1999 report found that 91% of clients in Indiana renewed their loans, with an average of ten renewals, indicating that many loans are not truly short-term.

Who is the typical payday loan customer?

Typical payday loan customers often come from working, lower, and middle-income backgrounds, with average annual earnings around $25,000. They are often women, single parents, or divorced individuals, and are more likely to have a history of bankruptcy.