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Payday loans

Understanding how payday loans work

published: 15 December 2021
Read time: 5 minutes

Everything you need to know about payday loans – the costs, the advantages and the pitfalls

What is a payday loan?

A payday loan is a short-term loan designed to tide you over until you get paid – hence the name. The maximum amount you can borrow is typically around £1,000, while the average term is just two to three weeks. 

Offered by high street and online lenders, payday loans offer a way to get your hands on some extra cash fast – to plug short-term financial gaps. But they are much more expensive than standard personal loans, which are generally for higher amounts, with a loan term of between one and 10 years.

Man looking at laptop, serious expression

How do payday loans work?

You can apply for a payday loan over the phone or online. If you’re accepted, the money is usually paid directly into your current account on the understanding that you will pay back the full amount borrowed, plus interest and any other fees and charges, within the agreed timeframe – typically this will be no more than 31 days. 

Most providers will ask you to set up a Continuous Payment Authority (CPA) to pay the debt off in one go. This enables the loan provider to take the payment automatically from your debit card on the agreed date.  

If for any reason the CPA fails to go through, you’ll start to incur even higher interest charges, plus hefty late payment fees will be added to your account. This is when payday loan debt can soon start to grow. 

What is the typical interest rate on a payday loan?

If you decide to take out a payday loan, you can generally expect to pay interest at an APR (Annual Percentage Rate) of around 1,250%. This works out at 0.8% per day, which is the maximum payday lenders can charge under rules brought in by the regulator the Financial Conduct Authority in 2015.

Borrowing £100 for 30 days at this rate will mean paying back £124, while borrowing £500 for the same time would equate to a total repayment of £620. 

This is much more than you would pay to borrow money on a standard credit card or bank overdraft, or via a personal or unsecured loan. For credit cards a typical APR would be around 17% to 20% depending on the provider, while most people would pay less than 8% for a £5,000 personal loan. In these cases the rates will depend on your credit score

The reason payday loans are so much more expensive is that they are considered higher risk due to their short-term nature and the financial situation of most applicants. That is, many borrowers will have a bad credit history and low credit score and so are seen by lenders as being at greater risk of defaulting on their loan.  

What do I need to consider before taking out a payday loan?

The most important thing to consider before taking out a payday loan is whether or not you will have the funds available to pay it off on time. If the answer to that question is no, or if there is any uncertainty, then a payday loan is the wrong choice. 

Consider whether there might be cheaper alternative ways for you to borrow. See our section on alternatives to payday loans below. 

How easy is it to get a payday loan?

To qualify for a payday loan, you must be over 18, with a regular income and a UK bank account. In most cases, you’ll also have to pass a credit check – lenders will look at your credit history to decide if they’ll lend you the money, although the checks are generally less stringent than those applied for bigger and longer-term loans.

You’re likely to have to agree to a continuous payment authority (CPA) that allows the loan provider to take the full repayment amount from your bank account automatically on an agreed date. 

What are the pros and cons of payday loans?

Payday loans can offer a quick, easy way to borrow a bit of extra cash when you need it. But this speed and convenience comes at a high price. Here are some of the pros and cons to consider:  

Advantages of a payday loan

  • Easy: it’s often easier to be accepted as the related credit checks are less stringent 

  • Quick: the application process is generally fast and straightforward

  • Handy: you can borrow small amounts, for example from around £100 

Disadvantages of payday loans

  • Expensive: with average APRs of 1,250%, payday loans should only be seen as a last resort 

  • Late fees: usually charged immediately if you miss the repayment date

  • Risky: needing a payday loan is often a sign your finances are spiralling out of control. Seek free and independent debt advice if you are worried about your finances 

  • Short term: these loans aren’t suitable for long term borrowing, you’ll typically have to repay within a month

How to pay off a payday loan?

To pay back a payday loan, all you usually have to do is ensure there is enough money in your bank account to cover the CPA payment on the date it is due. Be aware if you fail to make this payment you’ll be hit with late payment penalty fees and potentially higher interest rates. 

Will a payday loan harm my credit score?

Payday loans are likely to be recorded on your credit file, but taking one out should not adversely affect your credit score if it is repaid on time. 

That said, being unable to repay a payday loan on time could have a big negative impact on your credit score – especially if your case ends up in court or is passed on to a debt collector. 

It has been reported that some lenders might take a negative view of a borrower who has used payday loans, even if they were repaid on time, as they feel this could be a sign of financial strain. But it is impossible to know if this is a reason for being declined other credit, such as a credit card, loan or mortgage - as it will be just one factor among many when providers make their decisions about lending to you.

Can I consolidate my payday loan?

Yes, it is possible to consolidate payday loans using another form of credit, such as a personal loan. Consolidating debts can make life simpler as you only have one repayment to make each month, rather than several different ones. 

It can also help to make your debts cheaper to pay off, especially high-cost credit, such as payday loans. Bear in mind however, that taking on further debt could damage your credit score. 

Can I get a payday loan on benefits?

Payday loans are designed for people who work and receive a regular income with which they can repay the loan within a few weeks. So even if some payday loan providers accept applications from people on benefits, it’s not advisable to take out a payday loan when you do not have a job or regular income. 

It’s an expensive way to borrow money and the chances of you not being able to pay it off on time are higher, so you’re more likely to end up paying high interest and charges. 

Can I cancel my payday loan?

Payday loans generally have cooling off periods of around 14 days, during which you can change your mind and cancel the loan. You’ll still have to pay interest on any money you’ve already spent, but you’ll be refunded any other fees or charges you’ve paid.

What happens if I can’t pay back my payday loan?

If you’re going to struggle to repay your payday loan and you need the money in your bank account for things like rent or bills, you can cancel your automatic CPA payday loan repayment – or any other planned payments such as standing orders, direct debits, and post-dated cheques – by contacting your bank. 

Remember though that this needs to be done at least one day before the payment is due to be made, otherwise your bank may not be able to stop the payment from going through. 

This will mean you will default on your payday loan and this is likely to lead to penalty charges and more interest – and could have a negative impact on your credit score.  

If you think you won’t be able to repay the loan on time contact your provider and explain your situation. It is always worth asking your lender if you can work out a repayment plan. You can find out more about your options with our guide to missing loan repayments due to financial difficulty.   

If you have concerns about your finances there are also several debt charities where you can get free and independent advice. These include:

What are the alternatives to payday loans?

Payday loans should be only be taken out as a last resort due to their high costs and the risk of pushing you into further debt. Where possible and appropriate, consider alternative options such as:   

  • Personal loans

    personal loan can be a much cheaper way to borrow money compared to a payday loan. You might have to wait a bit longer for the cash, but the interest rate you pay will be much lower – even if you have a low credit score. The actual APR you’ll be offered will depend on factors such as how much you want to borrow, how long you want to pay it back, and your credit history.  

    Most personal loans must be taken out over at least one year, while the amount you can borrow is usually between £1,000 and £25,000, again depending on your circumstances.

  • Credit cards

    The interest rate on credit cards is low compared to payday loans, and if you pay off your balance in full every month then you won’t pay any interest at all. However, this only applies to making purchases; using your credit card in other ways (cash withdrawals for example) may result in charges and fees.

    There are even credit builder cards designed to help people with low credit scores and those with no credit history. Used carefully you can start to improve your credit score over time. Be aware they can also have relatively high interest rates if you don’t pay off your balance in full each month. 

  • Authorised overdraft

    Another potentially cheaper way to borrow money is to ask your current account provider for an authorised overdraft facility. If you’re prepared to switch accounts, you may even be able to get an interest-free overdraft for a set period of time.   

  • Family and friends

    Borrowing from a friend or member of your family can help you to avoid taking out a payday loan. But to protect your relationship, it’s important to put the loan agreement down in writing, to make sure all parties involved know exactly what the deal involves and when you’ll repay.  

    Set up a repayment plan and discuss what will happen if you are unable to make a repayment, so you can resolve any issues amicably.  

Other useful guides

Compare loans with MoneySuperMarket

Payday loans are expensive and best avoided so we don’t offer them on MoneySuperMarket. But we can help you compare a wide range of secured and unsecured loans. 

All you need to do is tell us a bit about why you need the loan, how much you want to borrow and over what time frame and we’ll give you a list of loans tailored precisely to your requirements.  

You’ll be able to see the interest rate, the overall cost of the loan per month, and any fees and charges attached. We’ll also show you how likely you are to be accepted for each loan so you can apply with greater confidence. Searching in this way doesn’t have an impact on your credit file or score as we use a ‘soft search’.

Once you’ve found the most suitable deal, just click through to finalise the deal with the provider. 

Moneysupermarket is a credit broker – this means we’ll show you products offered by lenders. We never take a fee from customers for this broking service. Instead we are usually paid a fee by the lenders – though the size of that payment doesn’t affect how we show products to customers.

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