How payday loans affect your credit score

• Find out what a payday loan is and how it works.
• Understand the pros and cons of a payday loan, and how it impacts your credit score.
• Discover the alternatives to an expensive payday loan.

A payday loan can appear to be a convenient solution if you are cash-strapped and need funds urgently. But despite the perceived benefits, payday loans can be expensive.

Besides the potential of pushing you into a debt spiral, a payday loan can also impact your credit score negatively, making it harder for you to borrow money from a mainstream lender.

Read on to learn more before taking out a loan.

What is a payday loan?

​​Payday loans, also known as short-term cash loans, are a form of personal loan for terms ranging between 16 days to one year. With a payday loan, you can borrow up to $2,000 within a few hours.

However, even though a payday can help you meet an immediate cash requirement, the attached terms and conditions, including high establishment fees and interest rates, could see you paying a lot of money for borrowing a small amount.

To safeguard the interests of consumers, ASIC has capped the fees charged on short-term loans of less than $2,000 for a term between 16 days and one year. It also lays down that a credit provider cannot collect more than 200% of the amount loaned to you if you miss a payment or fail to repay the loan.

Does using a payday loan impact my credit score?

Like any other form of credit, using a payday loan will have an impact on your credit report and score.

The first effect happens when you apply for a loan. While some payday lenders will not make a ‘hard enquiry’ on your credit file (meaning that they will not ask a credit reporting agency for a copy of your file), many will do so, and this fact will be recorded on your file, temporarily taking your score down a point or two. If you make lots of payday loan applications, those downward points can quickly add up, and it could also make you appear credit hungry to lenders.

Secondly, if your application is successful, the amount you borrowed, the loan type, and the opening and closing dates of the account, will be recorded in your credit file, for other lenders to see when enquiring about your credit history. A payday loan record may make an unfavourable impression.

Finally, if you cannot repay the loan in full and on time, a default will be listed on your credit report that will again pull down your score. This default will be visible to other lenders when you apply for a loan in future and may lead them to believe that you are not responsible with managing money.

Being rejected for a payday loan will not affect your credit score, because the rejection isn’t reported and will not appear in your credit file. But if a rejection prompts you to make a further application with another lender, the resulting hard enquiry will reduce your score.

Can a payday loan impact my personal loan application?

Most banks and other traditional lenders carry out several income and expense checks before approving an application for credit. They also look over your credit history to assess your financial habits and determine how much of a risk you pose as a borrower. While every lender has unique assessment criteria, some of the factors remain common, such as the number of credit applications you make, the amount of active credit you have, the type and duration of your existing loans and your overall credit limits.

Usually, a payday loan will not directly impact your ability to take out a personal loan. However, if your credit report is very active with multiple applications for payday loans appearing on it, it can adversely impact your chances of getting approved for a loan. There are also some companies that see payday loans in a negative light. Having a few payday loans on your credit report could lead them to believe you cannot manage your money and perceive you as a less reliable borrower.

However, most lenders will not judge you for using a payday loan if you paid it in full and on time and generally possess a good credit score.

How does a payday loan impact my home loan application?

Even though a payday loan may not impact your credit score significantly, some lenders may reject your mortgage application based on the payday loans used by you in the past.

Payday loans are often considered as quick-fixes to tide over financial emergencies. If you applied for several payday loans in the past, it might give an impression that you find it hard to budget or manage your expenses within the amount you earn. So, even if you repay a short-term loan in full, it may signify poor financial management depending on your overall credit history, causing a lender to decline your application for a home loan.

Is it possible to improve my credit score with a payday loan?

Managing your debt responsibly is generally a positive for your credit report, because positive information – such as consistent, on-time loan repayments – is also recorded, and will boost your score.

Good credit management for both long and short-term loans is also vital for your credit health. Making loan repayments on time can prevent payment defaults from appearing on your credit file, which can help maintain your credit score.

What are the risks associated with a payday loan?

Payday loans are an expensive way of borrowing money, and should be considered as a last resort for overcoming a financial emergency. If you take out a payday loan, it could give other lenders the idea that you are having difficulty managing your money.

While a single payday application may not make much of a difference, multiple payday loan applications, rejections and defaults can negatively impact your credit score and make it difficult for you to qualify for a car loan, personal loan or home loan in future.

Perhaps the most significant risk of a payday loan is getting trapped in a cycle of debt. Though licensed lenders can’t charge any interest on payday loans, they can charge you a lot in fees. Payday lenders may charge you an establishment fee of 20% of the amount borrowed and a monthly account-keeping fee of 4% of the amount borrowed. For a $1,000 loan, that’s a $200 establishment fee and a $40 monthly fee. Therefore, you generally end up paying much more than what you borrowed. If you are on a tight budget, repaying the debt could be problematic, and you may find yourself scrambling for more credit to pay off the existing debt.

Alternatives to a payday loan

A payday loan isn’t your only option for paying off an emergency expense. Here are some of the alternatives to a payday loan you may want to consider:

• A personal loan. The interest rate on a personal loan is generally much lower than the effective rate you’ll pay for a payday loan. However, you usually require a good to excellent credit score to be eligible for a personal loan.
• A no-interest loan. Designed for low-income individuals and families, and Centrelink pensioners or Health Care Card holders, the No Interest Loan Scheme allows eligible applicants to borrow up to $1,500 for 12 to 18 months to pay for essentials like fridges, washing machines and car repairs. You only repay what you borrow under the scheme, as no interest, fees or other charges are applicable. However, you can only apply for the scheme if your after-tax income is less than $45,000 annually.
• Buy Now Pay Later (BNPL). A buy now pay later service allows you to purchase goods and services and pay for them in instalments spread out over a few weeks or months. Most BNPL services offer you an interest-free period to pay off your purchases. However, you’ll be hit by a late payment fee if you are unable to repay the full amount within the agreed period. BNPL firms don’t generally carry out a hard credit check before approving you for a transaction. Therefore, you can borrow small amounts quickly and pay them off without any interest charges if you can keep up with the repayment schedule.
• Centrelink advance. You may be able to receive an advance payment on your Centrelink income, with no interest payable. The repayments are generally deducted from your future Centrelink income, and you don’t need to do anything to set up your repayments.
• Access your own pay before payday. Access a portion of your wages before payday via services like Beforepay and MyPayNow.

How can I improve my credit score?

Under the comprehensive credit regime, positive financial behaviour is recorded on your credit report and can help improve your credit score. Therefore, simply paying your bills on time and not defaulting on your payments can help you boost your credit score over time.

You should also monitor your credit report for any incorrect listings and check it before applying for a loan or credit card to minimise the chances of rejection.

Here are five tips to improve your credit score:

• Pay all your bills and make loan repayments on time.
• Try to pay off your credit card balance in full each month.
• Try to pay off your outstanding debts to keep your credit utilisation low.
• Do your research before applying for a loan to minimise the number of enquiries on your file.
• Diversify your credit with a mix of short-term, long-term and revolving credit to help improve your credit score. However, make sure you can afford the money you borrow to make timely payments and avoid any defaults from appearing on your credit report.

The bottom line

Payday loans provide an easy source of credit to people who are sometimes left behind by traditional lenders, owing to lower incomes or bad debts in the past.

A payday loan could give you access to instant cash to make an emergency purchase. However, it could also push you into a debt spiral if you cannot afford the high costs associated with the loan.

Therefore, unless you are in dire need, it may be better to avoid an expensive payday loan. If you have existing payday loans, try to pay them off and then wait for at least three months before applying for a car loan, personal loan or home loan, to avoid rejection.