Explainer: How do payday loans work?

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Photo by Andrea Piacquadio from Pexels

Captain Cash, Mr. Payday, Speedy Cash and Cash 4 You—payday loan companies market themselves as an informal, cheery alternative to the conventional banking system, one that provides easy access to funds you might need to smooth out small financial emergencies. But are payday lenders helping meet a vital need for Canadians who are left behind by the mainstream financial services industry, or are they exploitative businesses taking advantage of people with few borrowing alternatives?

What is a payday loan?

Despite their name, “payday loans” are not actually loans against a future paycheque. Instead, they’re short-term, high-interest-rate loans from a third party (not your employer) with terms designed to coincide with a typical two-week pay cycle. In Canada, payday loans are regulated by the provinces. Usually, you can borrow up to 50% of the take-home pay expected on your next paycheque. The full amount of the loan—principal plus interest—is then normally due in two weeks. The interest rate on a payday loan, calculated on an annualized basis (as if the funds were borrowed for a full year) is far in excess of allowable rates for other credit products, such bank loans, lines of credit and credit cards. (We explain this in full below.) A payday loan might charge up to 400% or more, calculated as an annualized percentage rate; in contrast, a loan from a bank or credit union might charge 5% per year, while the interest rate on a credit card might range from 12% to 20%.

What’s wrong with payday loans?

Proponents argue that payday loans fill a legitimate requirement for quick, easy-to-access cash to help people meet unexpected financial shortfalls, and refer to the growing rate of payday loan use as evidence for their need. (The federal Financial Consumer Agency of Canada reported in 2014 that usage of payday loans doubled from 2009 to 2014, from 1.9% to 4.3% of Canadian households.) Critics of payday loans, on the other hand, point to their very high interest rates and their inflexible terms, which require a single, full repayment of principal and interest, as “predatory” features that take advantage of vulnerable or unsuspecting borrowers.

How much do payday loans cost?

Payday lenders are required to disclose the rates they charge expressed as an “annualized percentage rate,” or APR. The APR is used, and required in many lending contexts in Canada, as a way to provide consumers with an easy way to compare loan rates for different products, even if the borrowing period is for less than a year. The interest rates payday lenders can charge are set by the provincial governments in provinces that have opted to regulate payday lenders. (None of Canada’s territorial governments has regulated payday lenders.) Here are the rates for each province:

Province	Maximum charge per $100 loan	Annualized percentage rate for payday loans (based on a two-week loan)
Alberta	$15	391%
British Columbia	$15	391%
Manitoba	$17	443%
New Brunswick	$15	391%
Newfoundland and Labrador	$14	365%
Nova Scotia	$17	443%
Ontario	$15	391%
Prince Edward Island	$15	391%
Quebec	n/a	35%
Saskatchewan	$17	443%

The annual percentage interest rate (APR) for payday loans is calculated by dividing the amount of interest and fees paid by the amount borrowed, multiplying the result by 365, dividing that number by the length of repayment term in days, and multiplying by 100. For example, for a two-week loan charging $15 per $100 borrowed, the APR = (((15 / 100) x 365) / 14) x 100 = 391%.

Why can payday loans charge such high interest rates?

While the Criminal Code of Canada prohibits annual percentage rates in excess of 60%, 2007 amendments to the Code specifically exempt payday lenders from the rules other lenders must follow. In order to qualify for the exemption, payday loans must be small ($1,500 or less), short-term (such as for 62 days or less), and must be made in provinces that have opted to regulate payday lenders with legislation to “protect recipients of payday loans and…specify a limit on the total cost of those loans.” Because the Criminal Code amendments allow provinces to set the maximum borrowing limit for payday loans, borrowers can face significantly different interest rates depending on where they live. In the nine provinces with active brick-and-mortar payday loan businesses, rates vary from 391% per year (in five provinces) to 548% per year (in Newfoundland and Labrador, which is the most recent province to regulate payday lenders). In Quebec, however, the government has set the maximum payday loan interest rate at 35% per year—well below the 60% “usury” rates in the criminal code. As a result, no payday lenders have set up shop in the province (although Quebecers, along with any other Canadians, can borrow from online payday lenders that don’t have a physical presence in their province). Quebec’s Consumer Protection Act requires that a lender have a license to operate in the province, and Quebec’s courts have decided to grant licenses only if the creditor charges less than 35% per year because the loan is otherwise “unconscionable” under the Act. The amendments to the Criminal Code were made in 2007, after the Payday Loan Association of Canada, which was formed in 2004 and is now the Canadian Consumer Finance Association, successfully lobbied for the change. Until the Criminal Code amendments and subsequent development of regulation by provincial governments, payday lenders had been operating in a legal grey zone. That’s largely because they don’t easily fit into the traditional “four pillars” of the Canadian financial system: banks, trust companies, insurance companies and securities firms. As the payday loan industry grew in the 1980s and 1990s, payday lenders became worried that they might be regulated or even sued out of business (via class-action lawsuits launched by consumers), as they were clearly operating in violation of the Criminal Code interest-rate limits. In order to survive, payday lenders needed to find a way to operate legally. According to Olena Kobzar, a social sciences professor at York University who completed her doctoral thesis on payday lending in Canada, this meant embracing some regulation. Embracing regulation, in turn, “meant convincing the federal government to change the section of the Criminal Code that made payday loans illegal.” The Criminal-Code changes came in the form of Bill C-26, introduced in the federal parliament in October 2006 and passed into law in May 2007. As with, for example, a 1985 Criminal Code amendment allowing the provinces to operate, license and regulate many forms of now-decriminalized gambling, the payday loans amendment was passed swiftly and without public consultation.

Who uses payday loans?

The target user of payday loans in Canada is the so-called “ALICE” demographic: consumers who are Asset-Limited, Income-Constrained and Employed. In practice, the typical payday loan borrower largely fits within that definition, as Canadian payday loan users are more likely to be female single parents who rent (not own) their home. Research carried out by the Financial Consumer Agency of Canada in 2016 showed that renter households were four times more likely to use payday loans than home-owning households, and single-parent households were almost four times more likely than two-parent households to use payday loans, with female-led households more at risk than male-led households. In short: although the proportion of Canadians who use payday loans is small, it is concentrated in specific types of households. These findings are also borne out in the 2020 Hoyes Michalos “Joe Debtor” bankruptcy study. Looking only at consumers who filed for relief from their debts, the study found that about two in five (38%) of insolvent consumers had payday loans, and the average amount of payday loan debt rose by 13% from the 2019 study. (The 2020 study also notes that while the Canada Emergency Response Benefit could not be garnisheed by creditors, payday lenders were willing to lend money to Canadians collecting either CERB or employment insurance benefits—stretching the meaning of “payday loans” beyond their original intent.) Perhaps the biggest issue with payday loans, however, is not so much who uses them, but how they are used. A significant proportion of payday borrowers take out many loans a year, notes Chris Robinson, finance professor at the School of Administrative Studies at York University: “They are borrowing just to repay the previous loan, the total fees are a significant cost relative to their limited income and the repayment of principal alone on the next payday is likely to be a significant hardship.” This means, for payday loan users, the loans can be a kind of debt trap that becomes increasingly difficult to escape. “There’s a certain inequality to affordable credit in Canada,” adds Brian Dijkema, vice-president of external affairs with Cardus, a Canadian charity which has extensively researched payday loans. Cardus recently undertook polling research with the Angus Reid Institute, which found that one-third of respondents “could not definitively say they have friends or family members they could count on to provide financial assistance in an emergency.” Dijkema adds: “One way to ensure that people on the economic margins have access to reasonably-costed credit is to be open to the development of unique solutions—through technology or social networks, for example—that can provide positive examples of low-dollar lending.”

What are the alternatives to payday loans in Canada?

Today, there are several companies working to disrupt the payday loan business in Canada by introducing new payment flexibility that didn’t previously exist. One is ZayZoon, established in 2014 and headquartered in Calgary. ZayZoon is a pioneer in what’s known as Earned Wage Access (EWA), an employer-sponsored benefit that allows employees to withdraw income they’ve earned between traditional pay cycles. No interest is charged, but each transaction requires a flat $5 fee that’s repaid when the funds are returned out of the employee’s next paycheque. ZayZoon says they’re available to “millions of employees” through partnerships with more than 2,000 businesses across the U.S., Canada and Australia. “With ZayZoon,” comments co-founder and president Tate Hackert, “employees can create a profile, log in, and access money they’ve already earned but haven’t [yet] been paid in about five minutes.” ZayZoon does more than just alleviate short-term cash crunches, though, according to Hackert: “We view ourselves as an HR technology and financial wellness company. Along with accelerated access to wages, we also provide budgeting tools and financial education that helps employees take control over their finances.” Another is Benefi, an innovative employee benefits program, founded in 2019 and planning to launch in the next few months, that helps employees from participating companies access low-rate loans that are secured against their paycheque. “We combine a better way to borrow with financial literacy and helping employees save,” comments founder and CEO Patrick Dunn. To date, the company has signed up several companies with at least 300 employees each, covering the advertising, technology and consumer packaged goods industries, and they’re expecting to be available to more than 3,000 employees when they launch. Benefi loans are offered as an employee benefit and are repayable over up to 36 months (in contrast to the immediate repayment requirements for a payday loan). “Then, once the loan is repaid, the borrower can opt to keep contributing the same amount to a savings account, to build up an emergency fund so they don’t need to rely on loans to meet short-term needs,” Dunn adds. “Our goal is to help consumers reduce their reliance on consumer debt in the short term by providing borrowing alternatives, while also providing the tools that will allow them to remain debt-free in the long term.” In the US, a startup called Instant Financial allows employees to access half of their daily pay as soon as their shift ends. DailyPay is a similar daily payment platform. “It’s worth noting, however, that all of these programs privilege full-time salaried workers,” comments public policy strategist Vass Bednar, meaning that people with precarious employment “may again have fewer options.” Bednar adds: “The persistence of payday loans post-regulation is an indicator of the need for more flexible banking products that help Canadians access funds when they need them.”