Payday Loans vs. Personal Loans: An Overview
If you need to borrow money, you have some options. For example, you can consider an easy-to-obtain payday loan for small amounts if you believe you can repay what you’ll owe with your next paycheck. On the other hand, you might prefer a personal loan despite the application process because it will provide you with more funds, cost you less, and involve a longer repayment term.
Payday loans and personal loans have the same essential characteristics that are common to all loan types. Money is borrowed for a period of time at a specific interest rate and must be paid back by a particular date. Furthermore, the money can be borrowed for various reasons, although the payday lender doesn’t need to know the loan’s purpose, while the personal lender will probably ask.
However, these loans vary significantly in ways that can have a big impact on the borrower: the approval process, the cost of the loan, the length of the repayment period, the risk of added debt, and more.
Key Takeaways
- A payday or personal loan can provide the funds you need for unexpected financial emergencies.
- Payday loans can come with very high interest rates and hidden fees.
- Personal loans require an application but charge lower interest rates and offer a generous amount of repayment time.
- Because of late fees that increase the amount owed, payday loans can be risky for borrowers who can’t pay them off when they’re due.
- Payday loan lenders usually don’t report loans to credit bureaus unless borrowers fail to pay.
How Payday Loans Work
Payday loans are short-term unsecured loans that are very easy to obtain. With their ease of access comes predatory fees and interest; they are currently illegal or restricted in 18 states and the District of Columbia.
Easy to Obtain
Payday loans involve relatively small amounts of money. Moreover, lenders might request proof of income, but they won’t require collateral to secure your loan. Broadly, they make no specific determination of whether or not a borrower can repay a loan.
Normally, they’ll simply request that you provide them access to your financial account electronically so that they can withdraw the money you owe on the date it must be repaid. Or, they may request a handwritten personal check for the amount owed, which they’ll deposit on the due date.
Short Repayment Term
Payday loans are intended to be paid off quickly. Typically, this means in a couple of weeks or by the time a borrower receives their next paycheck or pension check.
Borrowers can get into greater debt and financial trouble by failing to meet the repayment due date. If that occurs, lenders will tack on high late payment fees, making it much harder to pay off the amount owed.
Although payday loans don’t impact your credit when you borrow, they may be sent to collections if you fail to repay the loan. At that time, they may lower your credit score due to delinquency.
Expensive to Borrow
Those who make payday loans usually charge exorbitantly high interest rates. This rate can average 400% and be as much as 780%.
Because of these rates and the fees that lenders charge, some consider payday loans predatory.
Eighteen states and the District of Columbia prohibit payday loans:
- Arizona
- Arkansas
- Connecticut
- District of Columbia
- Georgia
- Illinois
- Maryland
- Massachusetts
- Montana
- Nebraska
- New Hampshire
- New Jersey
- New Mexico
- New York
- North Carolina
- Pennsylvania
- South Dakota
- Vermont
- West Virginia
In several states, payday loans are legal but have some restrictions:
- Colorado
- Kentucky
- Mississippi
- South Dakota
In all other states, payday lending is legal.
Each state that allows payday loans applies its own laws to lenders to restrict interest rates and fees and thus protect consumers.
According to the Consumer Financial Protection Bureau (CFPB), the majority of payday loans aren’t paid off on time.
Single-payment payday loans, with their approximately 400% annual percentage rate (APR), have been found to lead to borrowers being trapped in an ongoing sequence of debt.
How Personal Loans Work
Personal loans are installment loans. They can be secured or unsecured, but they always have longer terms and lower interest rates than payday loans. Unlike with a payday loan, lenders evaluate your credit history to discern whether you can repay a personal loan.
Complete an Application
A personal loan involves a visit to a financial institution that makes personal loans, followed by a loan application. You can also visit a lender online if you prefer.
Whether or not the lender gives you a loan depends on your application and whether you accept the terms of the loan. These terms will include the amount loaned, the interest rate to be charged, the repayment dates and overall term, late fees, etc.
If your loan is approved, the lender will provide you the funds via a direct deposit to your bank account or by check. After the loan is funded, you can use the money as you see fit.
Secured or Unsecured Loans
Personal loans may be either secured or unsecured. For instance, a lender may require that you provide collateral for any loan they make. If you fail to repay the loan, the lender will keep this collateral. The collateral could be some form of financial asset, such as securities or a certificate of deposit (CD). Or it could be a physical asset, such as a car.
Some lenders may offer unsecured loans, but these may come with higher interest rates due to the lack of collateral.
Requirements
Lenders normally require a particular credit score, a certain income level, and a specific debt-to-income (DTI) ratio for the personal loans consumers seek.
Usually, the better your credit rating, the lower the interest rate that you may be offered for a personal loan.
How Do People Use Personal Loans?
Investopedia commissioned a national survey of 962 U.S. adults from Aug. 14, 2023, to Sept. 15, 2023, who had taken out a personal loan, to learn how they used their loan proceeds and how they might use future personal loans. Debt consolidation was the most common reason why people borrowed money, followed by home improvement and other large expenditures.
Key Differences
There are several notable differences between payday loans and personal loans:
- Use: People usually seek payday loans of around $500 for unexpected financial needs and plan to repay them within a couple of weeks. Personal loans are usually sought to finance a major purchase, to consolidate debt, or perhaps to make needed repairs. They have much longer repayment periods.
- Cost: Payday loans have much higher interest rates than personal loans and may overwhelm borrowers with hidden fees and charges.
- Accessibility: Payday loans can be easier to obtain than personal loans because they have few requirements. With some payday lenders, you can even get a loan without a bank account as long as you have a prepaid card account.
- Credit score impact: Most payday lenders don’t report your loan to credit bureaus, and paying it off doesn’t help you build or improve your credit. On the other hand, personal loans will appear on your credit report, and on-time personal loan payments can help you to improve your credit score.
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Do Payday Loans Help Your Credit?
Not usually. When made, payday loans aren’t reported to the three major national credit-reporting companies, so they are unlikely to impact your credit scores when paid back on time. However, if you fail to pay off your loan, you could be referred to a debt collection agency, which would hurt your credit score.
Are Payday Loans Hard or Easy to Pay Back?
Payday loans can be harder to repay than a personal loan, as the lender does not verify your ability to repay before lending you money. Payday lenders don’t generally assess your debt-to-income (DTI) ratio or consider your other debts before granting you a loan. Plus, if you miss a payment, the payday lender tacks on high fees that can increase the amount you already owe.
Is a Personal Loan a Good Alternative to a Payday Loan?
A personal loan is usually cheaper than a payday loan due to its lower interest rates. In addition, personal loans give a borrower more time to pay off a loan than a payday loan.
The Bottom Line
Payday loans are almost always more expensive than personal loans. They can also be riskier since added fees can increase the debt to a level that’s difficult to pay off quickly.
A personal loan is usually the better borrowing option, even for small loan amounts. And if you can’t get a personal loan, it might be wiser to try to borrow from family members or with your credit card before seeking a payday loan (unless you’re absolutely sure you’ll be able to repay on time).
