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In 2009, Consumer Focus research showed that 1.2 million payday loans were taken out, four times the number extended four years before.

That year, consumers borrowed £1.2bn and often paid for the privilege in interest rates of well over a thousand percent.

In December 2011, 3.5 million people - or 7% of the UK population - were considering taking out a payday loan in the next six months, according to research released R3, a trade body representing insolvency practitioners.

If R3's figures turn out to be anywhere near accurate, the huge rise in the number of people taking out this controversial product will be of concern to many. In this guide we look at why exactly that is and what regulators and politicians propose to do about it.

Payday loans: how they work

Payday loans are a short-term, high-interest borrowing option, as the nickname suggests, they're meant to tide the borrower over until they get their monthly pay packet.

Fees and interest

Payday lenders generally charge a flat fee for borrowing - usually around £5 to £10 - as well as interest, although the total cost is expressed as a set amount. So, as in the example below, a payday lender might ask for £15 for £100 lent over a week.

However, all or some of that £15 is an interest charge, which means that if the loan is not repaid within the agreed period, the cost of the borrowing will increase. This leads to some terrifying representative APRs:

Amount borrowed	Over...	Total to pay (no fees)	Expressed as a representative APR
£100	28 days	£25	1737%
£100	15 days	£19.50	4214%

As of 1 February 2011, all loan providers have been required to show a representative interest rate when they advertise borrowing. However, the 'representative' APR isn't particularly representative in this case.

Unlike traditional loan providers, Payday lenders don't charge compound interest.

Instead, if a loan goes unpaid there'll be a fee to pay and then interest will accrue on the balance for a set period, usually around 60 days, before the lender attempts, again, to have the borrower pay back the full amount.

Rollovers

However it's expressed, though, the key point is that rolling over a payday loan - not paying the amount or not paying it off in full is an expensive business.

Many payday lenders actually encourage their users to roll over loans from month to month, asking only that the borrower pays the interest for that monthly period and sometimes also a fee, to keep the debt on their books.

By continually rolling over the loan amount, payday loan users can end up paying hundreds of pounds more than they originally intended to.

What's the problem?

For many, payday loans are a solution to a simple problem: a short-term lack of funds needs a short-term injection of funding and consumers are willing to pay for it.

What worries opponents of payday lending, however, is that the sector targets the most financially vulnerable consumers, the very poor and those already in debt, and make an already precarious situation even worse.

There is considerable evidence that that's the case.

The typical payday loan user has a lower income than the UK average, Consumer Focus research in 2009 found that 67% of payday loan users had an income below £25k, and is much more likely to consider that they have a poor credit rating.

Although there is some evidence that middle-income earners also use payday loans, they only seem to do so in high proportions with lenders who have stringent rules on applicant acceptance.

In addition, those who already have debts seem highly likely to use payday loans. For example, Citizens Advice report that 40% of their clients with a payday loan also have at least one other high-cost credit loan and, on average, those with a payday loan have eight debts in all.

However, low income alone isn't an indicator of financial vulnerability, the Citizen's Advice contribution is inevitably a little biased, by definition they see consumers who are struggling to cope, and payday loans aren't necessarily worse than mainstream short-term borrowing options.

Payday loans vs overdrafts and credit cards

For example, let's compare one of the payday lenders from above with the overdraft charges on Halifax's standard current account.

Halifax charge £1 a day for anyone who has an agreed overdraft amount and £5 a day for those without an arranged overdraft or who go beyond their agreed amount which works out as:

	Amount borrowed	Over...	Total to pay
Payday lender	£100	28 days	£25
Overdraft: Halifax arranged	£100	28 days	£28
Overdraft: Halifax unarranged	£100	28 days	£140

In addition, Halifax charge a fee for payments which are returned when a customer is in their overdraft although the calculation above assumes that they don't incur any of these (i.e. it assumes that they don't use their current account for a month, which seems unlikely).

Qualitative research shows that, for some, it's the fear of these extra fees and charges that encourages consumers to use payday loans.

The same study found that fees and confusing interest rates also drew many to payday loans who would have otherwise used store or credit cards.

Like some overdrafts, cards can be just as expensive as payday loans. Just before Christmas 2008, for example, MPs said they were 'disgusted' by an Argos card charging 222.7% p.a. interest, just as much as many payday lenders.

For more on how these products compare to payday loans, see our alternatives to payday loans guide.

Payday loans vs. illegal loan sharks

What payday lenders and the mainstream can agree on, however, is that payday loans are still preferable to illegal lenders.

A 2010 OFT campaign against illegal loan sharks pointed out that 165,000 households in the UK use illegal money lenders, half of them in the UK's most deprived areas.

Other research has shown that external pressures can increase the incidence of loan shark use even further.

The Real Cost of Christmas report, released in 2011 by think tank the Financial Inclusion Centre, estimated that £29 million in illegal doorstep loans were taken out during the 2010 festive season.

During that period, the report said, people borrowed an average of £300 from loan sharks and extortionate interest rates increased the amount owed to £825.

These illegal moneylenders not only charge far more than any regulated service - tens of thousands of percent - their methods when people can't pay up are nasty in the extreme.

What's the solution?

If the payday loan market is failing consumers, though, what's the solution.

Interest rate caps

For MPs such as Stella Creasy that's simple: an interest rate cap.

Caps on store and credit cards was an election promise of all of the three main parties and 59% of the public support an interest rate cap on payday loans, according to research from think tank Compass.

However, France, Germany and a number of US states already impose interest rate caps and there's no consensus on whether consumers have benefited since the cap effectively kills the market, leaving consumers in need of credit with very few options.

So far, research into the subject has proved inconclusive. In July 2011, the department for Business, Innovation and Skills (BIS) concluded that further research on rate caps is needed before Government can proceed.

Total cost of credit caps

That research will also look into a cap on the total cost a payday lender can charge.

It's an idea supported by Consumer Focus which has been advocating a cap on the number of rollovers a payday lender can offer their borrowers, at five per loan, as well as caps on the number of payday loans that can be extended to a single household.

Martin Lewis founder of Moneysavingexpert is another notable supporter of this solution.

"By capping APRs we'd kill the [payday loan] industry," he's written on his blog , "yet a well imposed total cost cap rather than interest rate cap wouldn't do that. It would just limit the danger these short term expensive loans have."

However, not everyone is in favour of some form of cap.

Credit Action, the money education charity, said in its response to a Government consolation [pdf] that they, "fear that caps, even if only applied to one specific section of the credit market, could create flight on the part of certain lenders which would prevent borrowers from meeting their needs and prospectively drive [illegal] loan shark activity."

Unsurprisingly, perhaps, the British Bankers Association is also, "strongly opposed to the use of price caps for consumer credit in any form" citing evidence of a "detrimental impact on consumers' abilities to access credit".

Greater regulation

In July 2011, the Consumer Finance Association (CFA), a trade body for many payday providers, released a new code of practice for the industry.

As of November 2012, short term lenders who are a member of the Consumer Finance Association, the Consumer Credit Trade Association, the BCCA or the Finance & Leasing Association - which is to say, almost all of them - have agreed to comply with a good practice charter overseen by independent observers.

The charter commits lenders to, for example, "set out clearly how continuous payment authority works" and the full document is available to view here [pdf] .

All in all, payday loans have become such a political hot potato that those who don't support very fierce regulation are more likely to keep schtum than not.

Boris Johnson, for example, came under fire for allowing Wonga to sponsor New Year tube travel.

Choose.net covers a wide range of financial products and aims to provide information for consumers no matter what their financial situation.

However, unlike other price comparison sites, we don't list payday lenders in our comparison tables. And we never will.

"We think fair borrowing should be widely available, not just an option for those with the very best credit records. Currently, the practices of payday lenders mean that isn't the case," Lyndsey Burton, founder of Choose says.

"We strongly support legislation that will reform this sector. As long as they're well implemented, we believe that rate or total cost of credit caps could help to prevent the poorest people in society from falling into unmanageable debt whilst still ensuring that consumers can benefit from borrowing."