What is a payday loan and how does it work?
A payday loan is a form of unsecured short-term borrowing facility that is lent out to retail consumers. In this type of borrowing structure, there is typically a repayment agreement that is activated in full when the borrower receives his/her next paycheque from his/her employer.
All things equal, a payday loan generally has a higher interest rate attached to it because of its unsecured nature. Because the loan is non-recourse to personal assets of the borrower, the lender for such types of debt has to assume a higher rate of risk for every dollar lent out. To be compensated for this outsized risk compared to secured loans, there is a higher borrowing fee i.e. interest rate, charged.
The principal amount of a payday loan is relatively smaller than other loans (generally in the $500 – $1000 range with an upper limit set by the federal regulator in Canada). In Canadian provinces and territories, these loans are mainly provided at retail stores or online by non-bank institutions that have to be registered with the Financial and Consumer Services Commission.
The loans are mostly structured to be repaid in a single payment via a post-dated cheque or pre-authorized electronic debit for the full balance. Assuming that the borrower does not repay the loan early, the cheque is then cashed in or the debit is withdrawn by the lender.