Payday loans are a form of high cost unsecured borrowing where you borrow a relatively small amount of money until your next payday.
If your boiler fails in the middle of winter or your car breaks down and you have no savings, a payday loan may be the only option. These same day online loan companies can be an enticing solution to cash flow woes.
Here’s what this article covers:
Short term loans for bad credit
With few proper affordability checks, the short-term payday loan sector was once a Wild West, indiscriminately lending to people with bad credit, low incomes, or those on welfare.
Some borrowers ended up falling into damaging debt cycles, rolling over payday loans with interest rates of 5,000% or more month after month until their small debts grew into large ones.
In 2014, the Financial Regulator intervened. The Financial Conduct Authority (FCA) cracked down on payday lenders with a set of new rules that caused the number of loans and the amount borrowed to fall by 35% in the first five months after the rule changes – culminating in that some payday loan companies went out of business.
The government crackdown has forced payday loan companies to lend more responsibly, with better terms for borrowers.
In practice this now means:
- Interest rates and fees are capped at a maximum of 0.8% per day
- There is a £15 cap on late payment charges
- Credits can only be renewed twice. Borrowers are charged a rollover fee to delay loan repayment
- A total cost cap of 100% applies. This means that interest, fees and charges cannot be higher than the amount originally borrowed. In other words, no borrower pays back more than double their loan
- Anyone who takes out a loan for 30 days pays no more than £24 in fees and interest for every £100 borrowed
- Lenders can only take up to two payments from customers’ bank accounts through a continuous payment authority, where the lender uses the customer’s debit card details to withdraw the funds
- Lenders are required to assess borrower affordability, which means FCA-regulated entities are required to conduct a credit check
- Advertisements for payday loans must include risk warnings and directions to free debt counseling
So these products are certainly not as bad as they used to be.
But what else do you need to consider before considering a payday loan? Let’s look at the pros and cons.
Read more: ‘I graduated with no debt’
Benefits of Payday Loans
Payday loans have some advantages, although these do not outweigh the disadvantages, which we will discuss in a moment.
- You could be approved even if you have a below average credit history – if the lender believes you can afford the repayments
- They are fast. For those who need urgent loans (including urgent loans for those with bad credit history), you could get the money in your bank the same day
- You can extend the loan up to twice before you pay it back, although you’ll have to pay more interest for it
- They are comfortable. You can apply for a loan over the phone and receive same-day loans even on weekends
But this convenience comes at a price.
Learn more: How to get a personal loan
Disadvantages of Payday Loans
- They’re expensive. Even an interest rate capped at 0.8% can add up over the term. For example, if you take out a loan of €200, the daily interest payment will be €1.60. Multiply that over 30 days and the payment is £48. Get overdue on your debt and the daily interest keeps piling up, and you’ll also get stung with the £15 late payment fee
- Regulated companies must conduct a credit check. Companies that offer payday loans can conduct a “soft search” — a less than full check of your credit history that is invisible to other lenders — when you apply. Or they will conduct a “hard search” – a thorough investigation that will be recorded on your credit file – if you accept the loan terms. Alternatively, there are unregulated companies that you should avoid as you have no consumer protection if they go bust
- You don’t look good. Having payday loans on your credit file can make you look unattractive to more established lenders
- Do you want to buy a house or a mortgage? For the above reason, they can ruin your chances of getting a mortgage
- A lender can take money from your account by a rolling payment authority. It may make two attempts to take those refunds, but if they bounce, you could end up with bank charges
- You risk falling into a spiral of debt where you take out a loan to repay your lost income every payday
While you could research the best payday loans, there are more ethical and cheaper alternatives if you are looking for an urgent loan.
Learn more: What happens to debt upon death?
Alternatives to payday loans
Here are a few alternative payday loans to consider first:
An agreed or authorized overdraft on your checking account means that your bank has agreed in advance to loan you a certain amount.
Annual interest rates on these overdrafts — the FCA banned banks from charging daily and monthly fees in April 2020 — range between about 15% and 40% between lenders.
Under the same FCA reforms, lenders can now charge no more for unarranged overdrafts than they do for authorized ones.
However, overdrafting without prior agreement can affect your creditworthiness and your bank will usually withdraw direct debit payments or check if you have insufficient funds in your account.
Learn more: Is it better to use an overdraft facility or a credit card?
You withdraw money from an ATM with a credit card.
It’s an expensive way of borrowing as you typically pay a fee plus interest from the time of withdrawal; The average credit card interest rate is 23% per year.
Credit card cash advances are also a warning sign to lenders that you may be mismanaging your money. Having these on your file could hurt your chances of getting competitively priced future loans.
You can use a money transfer credit card to transfer cash from a card to your bank account. You pay an upfront payment, but typically there is a 0% period when you pay no interest.
So you should treat it like a term loan and try to make up the balance during that time.
Top rated credit cards for money transfer
A personal loan allows you to borrow a fixed amount of money over a set period of time and repay a set amount each month.
It can be a cheaper form of borrowing as interest rates are currently very low. But you usually need a decent credit report to be accepted for an unsecured loan.
Learn more: Should I take out a bank loan or a credit card?
If you have a bad or limited credit history, you can borrow with a sponsor loan if you have a friend or family member with good credit who will co-sign as a guarantor.
This means that if you default on the loan, they agree to be liable for repayments. The risk is that you could end up straining your relationship with that person if they keep having to step in for you.
It is also important to note that guarantee loans can be expensive as they are likely to charge higher interest rates than other types of loans. According to figures from comparison website Gocompare, the annual interest rate can typically range from 25% to 70%.
Loans with bad credit
There are special loans for people with bad or short credit histories. However, the interest rates are very high compared to other types of credit – around 49% on average.
So unless you need an urgent loan, you should first work on improving your credit score in order to secure cheaper loans in the future.
Credit unions are an ethical alternative to payday lenders.
These unions offer affordable loans even if you have bad credit, and they usually lend without a credit check if you can show you have the funds to make the repayments.
They may ask you to set up a small regular savings plan when you borrow from them to reduce your need for re-borrowing. Usually, credit unions are affiliated with a local area or a profession or employer. So you have to meet their criteria to join.
If you have received certain benefits for six months or more, you may be eligible for a government household loan to cover essential household expenses.
These loans are interest-free, so you only pay back what you borrow. Repayments are automatically deducted from your benefits over a period of up to two years.
Learn more: Should I take out a personal loan to build credit?
Are Payday Loans Safe?
Is there such a thing as a secure payday loan? While they’re certainly a lot better than they were before 2014, they won’t do your credit profile any good because they make you look like a risk to lenders. This could prevent you from getting a cheaper loan and mortgage in the future.
While payday loans may seem quick and convenient, they are also expensive and can greatly aggravate a precarious financial situation.
Because there are many better options, payday loans should only be used as a last resort.
Learn more: Should I get a 40-year fixed-rate mortgage?