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From unexpected car repairs to impending Christmas present shopping - there are many reasons why someone may opt for a short-term (or payday) loan. Here we explain what they are and the pros and cons to consider if you are thinking about taking one out.

What is a payday loan?

A payday loan is often seen as an expensive way to resolve a temporary money issue. High street and internet lenders will offer loans of small amounts of money (typically £100-£1000) over a short period of time (0-3 months). They are designed to help when an unexpected expense crops up and your salary and savings cannot cover the cost.

What’s the disadvantages of taking a payday loan?

While they may seem useful, it’s important to think about what benefit the lender gets from issuing these loans. In the height of the payday loan era, lenders such as Ferratum and Wonga.com were charging a typical Annual Percentage Rate (APR) of 3,113% and 4,214% respectively.

To break it down, that means if you were to borrow £100 from Wonga.com at 4214% APR, you would owe 42 times that amount if you didn’t repay it after 1 year. That’s a cost of £4100 for borrowing just £100! Martin Lewis from MoneySavingExpert.com calculated that if you borrowed this amount from Wonga and didn’t repay after 7 years, you would owe £23.5 trillion! If you can’t imagine how big that number is, that’s because it’s nearly as much as all of the USA’s national debt.

While it seems ridiculous calculating these amounts in the abstract, it isn’t hard to see how some people were getting into serious money issues with these loans. The high interest rates meant that the amount people owe could quickly spiral out of control, especially when fees increased significantly with every missed payment. Many of these loans were handed out irresponsibly to borrowers that the lenders knew would not be able to make the repayments.

Thankfully, there are now safeguards in place to stop this. Since 2 January 2015, interest has been capped at 0.8% per day for payday loans. Regulation also states that no borrower should have to repay more than twice of what they borrowed. That being said, if you borrowed £100 at 0.8% APR per day over 20 days, you would owe £16 if this was repaid on time. By 90 days, you would then owe the maximum amount of double your loan - £200.

Are there advantages to a payday loan?

While payday loans seem to be bad, there can be some advantages to them…such as:

Payday loans can be easy to access. The money can be in your account within minutes after a quick online process, while a traditional bank loan can take longer, and may sometimes require you to physically go to the bank.
Payday loans can be good for people who do not have access to credit. They could have a bad credit history, or no credit history at all. If these people need a loan, this could be one of their only options. Payday loans also don’t use a hard credit check on you. A rejection on someone’s credit file can negatively affect their credit score, so many may opt for credit options where this is not a risk.
Lastly, a payday loan is an unsecured loan. This means that you don’t have to guarantee a piece of your property in order to get the loan. For example, when you get a mortgage, this is ‘secured’ by the house. This means that if you cannot make the repayments, the bank could take your house to cover your debts.

So, what’s the verdict on payday loans?

While there are some reasons why payday loans might be appropriate, you should always assess your other options before taking one out. There are various cheaper options available such as a 0% credit card, utilising an overdraft or visiting your local credit union. If you do opt for a payday loan, there are tools online to compare the best providers and ensure that you pay the least interest possible. There are also many organisations that offer free, impartial advice, like the Money Advice Service, so it’s always best to search online for the best option for you before committing to any credit agreement.

Written by Olivia Burn

Glossary box

APR - This stands for “annual percentage rate” and refers to the annual rate of interest charged to borrowers.

Interest - This is a cost charged by the lender to the borrower for the privilege of borrowing money. This is how banks make money from issuing loans.

Hard credit check - This is when a company (often someone you want to borrow money from e.g. bank, mobile phone company etc.) makes a complete check of your credit history. These checks are visible on your credit report and can negatively affect it if you are rejected by the lender.

Soft credit check - This is a check which is not visible on your credit report and do not affect your credit score. This could be when you check your own credit score, or allow a future employer to view it.

Secured loan - This is a loan which you guarantee against an item that you own. For example, if you borrowed £500 and secured it against your car, the lender could take your car away if you missed a repayment to cover the debt.

Unsecured loan - This is a loan where you do not need to guarantee any of your personal belongings. As the lender doesn’t have the safety net of using an agreed item as security, the interest rates are often higher to offset the risk to the lender.

Leducate Explains: Payday Loans