Payday Loans

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 Assuming that the borrower does not repay the loan early, the cheque is then cashed in or the debit is withdrawn by the lender.

What is the difference compared to other alternatives?

The most comparable alternative to a payday loan, wherein borrowers acquire short-term financing to assist with immediate expenses is a cash advance. To this end, there are two types of cash advances:

Type I is pretty synonymous with a payday loan where the lender provides a fixed principal amount that is tied to the borrower’s income and is intended to be repaid on the borrower’s next payday.

Type II is a structured as a line of credit where the cash advance offered is dependent on the unused credit limits on the borrower’s credit card rather than on income. This type of cash advance is provided directly by the credit card company (not the issuer) and receives the same type of treatment as any other ordinary purchase made with a credit card.

Depending on the borrower’s financial situation and credit card features, it may or may not be advantageous to have a credit card cash advance. Some key factors for borrowers to consider if choosing between these two options are current credit ratings and credit card contract terms with the bank. In some cases, credit card companies charge higher rates on cash advances than on ordinary credit purchases, so it is important for the borrower to understand the rate differential, and choose accordingly.

Borrower Rights in Canada:

Payday loans in Canada are governed by the Payday Loans Act, 2008, which was initiated to protect borrowers taking out these types of loans. As per the Act:

Factors to Consider:

There are also certain features that can pose risks to prospective borrowers, we’ve listed some of the most common ones below:

Interest: Depending on the duration that the loan is obtained for and the rate charged by the lender, payday loans can be an expensive form of financing compared to other short-term loans and/or credit cards. The table below illustrates this concept more clearly. Assuming $500 borrowed for 2 weeks, payments are as follows:

Payday Loan                 |                  Credit Card

              $75 at a 15% rate             |           ~$8 assuming a 23% APR

Rinse and Repeat: Often, borrowers find themselves in a cycle of debt wherein each paycheque goes towards the pay-down of existing loans, leaving little for the operating expenses they took out the loan for. The extensions of the loans as a consequence come with strings attached in the form of higher fees added to the original amount.

Predatory Practices: Non-sophisticated borrowers may be susceptible to lending practices that are intended to be unfavourable from the borrower’s perspective by exploiting contract loopholes or misleading marketing materials. It is therefore critical for consumers to find registered institutions that are vetted by regulatory authorities.

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