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Small Loans, Big Fees: Pitfalls of Payday Loans

May 2010

Barbara O'Neill, Ph.D., CFP®
Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension

Want to take a small step toward improving your finances? Avoid payday loans!

Payday loans are single-payment, short-term loans that are made in return for delayed deposit (typically within two weeks) of a borrower's postdated personal check (i.e., a check with a future date on it). These loans go by a variety of names that indicate that borrowers are receiving cash in advance of a future paycheck, including: cash advance loans, check advance loans, post-dated check loans, deferred deposit check loans, and quick cash loans.

The availability of payday loans varies from state to state. While they are illegal in some states (e.g., New Jersey, where a check cashing licensee cannot advance money in return for a postdated check), they are widely available in others (e.g., many southern and Midwest states). However many payday lenders operate on the Internet, sometimes from foreign countries, and people living anywhere in the U.S. can access their services. Therefore, it is important to understand how payday loans are structured and how much they cost.

Here's how payday loans work. A borrower writes a postdated personal check to the lender, typically to receive a sum between $100 and $500. The face amount of the check includes a fee in addition to the amount of cash received. The check amount to receive $100 of cash might be $115 or $120, of which $15 or $20 is a fee charged by the lender. Payday loan fees can seem "cheap" at first but, in reality, they are a very expensive way to borrow money when the amount of the fee is considered in relation to the short two-week length of the loan.

To understand the high cost of payday loans in relation to other forms of borrowing (e.g., credit cards, bank loans), it is necessary to convert the fee into an annual percentage rate or APR. An APR is the simple percentage cost of all finance charges over the life of a loan on an annual basis. The annual percentage rate for paying $15 to borrow $100 for two weeks is 390% (15% biweekly x 26 biweekly periods in a year = 390%).

What happens after two weeks? Depending on the lender, options at this time are to "redeem" the postdated check with $115 cash or to have the lender simply deposit it (this assumes that there are adequate funds in the borrower's checking account, of course). Unfortunately, many borrowers don't have enough money to repay the lender after two weeks. Perhaps they were behind on other bills or had some type of emergency. Their second option is to extend the payday loan with another fee (e.g., another $15 for the same $100 loan), which is referred to as a "rollover."

After a few roll-overs, the fee charged for payday loans can actually exceed the amount borrowed. Many people don't pay off these loans for months and, therefore, dig themselves deep into debt. If you extend a $100 loan three times (i.e., three more bi-weekly periods), you will have paid $60 to borrow $100: the original $15 fee plus $45 for three more extensions ($15 x 3). After six roll-overs, the finance charge (fees) will be greater than the amount originally borrowed.

The word "interest" is generally not used in payday lending agreements. Instead, payday lenders like to call their charges "fees." This way, they reason, they don't violate state usury laws which cap the amount of interest that can be charged on loans. Payday loan fees are exactly like interest charged on a credit card, though, except much higher. With all types of loans or credit, consumers pay a price to borrow money.

One study of payday lenders by the Consumer Federation of America found effective annual interest rates (APRs) ranging from 261% to 1,820%. While some states have recently passed rate caps and/or limits on payday loan roll-overs, payday lenders operating offshore are usually beyond the reach of U.S. laws.


  1. Rutgers
  2. Executive Dean of Agriculture and Natural Resources
  3. School of Environmental and Biological Sciences