What is a payday loan and how does it work?

Payday loans, which are short-term or small-amount loans, are a form of credit designed to provide quick access to cash, especially in emergency situations. However, it is important to understand that while these loans may seem like a quick solution, this option often comes with high costs in fees.

This text will detail how payday loans work, their costs, more affordable alternatives, and guidance for those considering this option.

How does a payday loan work?

Payday loans, also known as cash advances, salary loans, or small-value loans, are small, short-term, unsecured lines of credit. The name is associated with these types of loans due to their reliance on previous payroll or employment records.

Demystifying the term, payday loans can simply be considered as another form of short-term borrowing. Additionally, a payday loan is designed to be repaid quickly, usually by the borrower’s next payday. The repayment term is typically no longer than one year.

The main feature of these loans is the speed of money disbursement, which often can be credited to the borrower’s account on the same day as the application. However, it is important to note that the longer you take to pay off the loan, the more additional fees you will incur.

These loans are often used by people facing temporary financial difficulties who may not have access to other credit options due to a negative credit history. While they may seem like a quick solution, payday loans should be viewed as a last resort, given their costly nature and the high fees that may be associated with them. Also read: How to check your credit score.

The cost of payday loans

One of the most critical aspects to consider when applying for a payday loan is the associated costs; however, according to the law, there is a limit on most fees. The Australian Securities and Investments Commission (ASIC) regulates these fees, which include:

• Establishment fee: Lenders can charge a fee of up to 20% of the loan amount. This fee is charged at the beginning of the loan and can represent a significant cost, especially for small loans.
• Monthly fee: Lenders may also apply a monthly fee of up to 4% on the outstanding loan balance. This means that even if the loan is paid off in a short time, the borrower may end up paying significantly more than the initially requested amount.

Risks of payday loans

Payday loans, while they may offer a quick solution for financial emergencies, come with several risks that make them a costly and risky option. The main concerns include:

• High fees: The charges associated with these loans are typically extremely high, with limits even greater than those of traditional loans or credit cards. Payment delays can result in additional charges.
• Short terms and high payments: Repayments are tied to the borrower’s payday, which can lead to significant deductions from wages and financial difficulties if payments are not made on time.
• Debt cycle: Defaulting can result in additional fees and a debt cycle where interest accumulates rapidly, making financial recovery difficult and negatively affecting credit.

While they may be useful in emergency situations, payday loans are generally considered a bad idea compared to more sustainable alternatives, such as effective budgeting, bank credit, savings, or loans from family and friends. It is advisable to explore options like ‘earned wage access’ to avoid the pitfalls associated with these loans. Also read: How to budget? A 5-step guide.

Alternatives to payday loans

While payday loans may be attractive for their quick access to cash, there are alternatives that can be cheaper and less risky. Here are some options:

1. Interest-free loan schemes: Some nonprofit organizations offer emergency loans to eligible individuals, allowing borrowers to access smaller amounts without interest, fees, or charges. However, the eligibility criteria can be quite specific.
2. Buy now, pay later: This option allows consumers to pay for a purchase in four regular installments, usually over six weeks, instead of all at once. The approval process is relatively easy, often without interest or monthly fees, but it can encourage unnecessary spending.
3. Early pay apps: Some platforms allow you to access a portion of your paycheck in advance. While the access to cash is quick and easy, each withdrawal may come at a cost, making it expensive with regular use.
4. Debt consolidation: If you have multiple debts, consolidation can be a way to merge them into a single, more manageable loan, potentially with a lower interest rate. This option is more viable if the new debt is cheaper than the existing ones.
5. Centrelink advance: For those receiving payments from Centrelink, it is possible to request an advance on the next payment. This option is attractive as it does not involve interest or fees, and the amount withdrawn is deducted from future payments.

Financial consulting and assistance

If you are considering a payday loan to cover other debts, it is advisable to speak with a financial advisor. Many offer free or low-cost, confidential services that can help you understand your options and create a repayment plan.

Additionally, if you are struggling to pay your bills, it is important to contact your service provider immediately. They may offer assistance in creating a payment plan that does not involve taking out a payday loan.

Government and community organizations often provide discounts and vouchers that can help cover expenses such as utility or phone bills. Seeking assistance before incurring new debts can be a prudent strategy.

Final considerations

Payday loans may seem like a quick solution to financial problems, but their costly nature and associated risks make them an option to be considered with caution. It is crucial to evaluate all available alternatives and, if necessary, seek help from professionals who can provide financial guidance.

In summary, before deciding on a payday loan, consider whether there are other ways to obtain the necessary funding. If you find yourself in a difficult financial situation, seeking help is an important step and can make all the difference in your ability to manage your finances in the long term.