What’s the Difference Between a Payday Loan and an Installment Loan?

male lion sitting in the safari

If you’re looking to borrow, you may already know about payday loans—they’re fast, dangerous, and designed to take advantage of those in need. (Think of them as the jackal of the lending animal kingdom.) Is there a better option? Something just as fast, but… you know, not evil?
You bet there is.
When it comes to lending, consider the personal installment loan the noble lion, king of the lending jungle.

Payday Loans: Scavenging on your finances.

“Payday loans… can destroy a borrower’s credit and wipe out their bank account.”

Payday loans are short-term, unsecured loans that target the financially vulnerable—the low income, the elderly, and those without limited financial education. Payday lenders won’t perform a credit check and, depending on the restrictions in your state, they may not even check your income first.

Fast money without a credit check? What could be wrong?

Well, a lot. Payday loans charge unfair fees and massive interest rates, meaning they have extraordinarily high annual percentage rates (APRs)—the measurement that allows you to see the full cost of a loan.

Certified financial educator Maggie Germano (@MaggieGermano) says, “Payday loans usually turn out very negatively for the borrower. Interest rates and fees are sky-high and many people are unable to pay them back in time. Every time you miss your payment due date, the amount owed increases significantly. This makes it impossible for people living paycheck to paycheck to pay them off. This can destroy a borrower’s credit and wipe out their bank account.”

It may be tempting to try out the fast, risky option with the short payment terms, but don’t forget: it’s a trap. Read more about payday loans in our eBook How to Protect Yourself from Payday Loans and Predatory Lenders.

Installment Loans: The lion king of lending 

“A good installment [loan]… can actually build up your credit and [help you] qualify for a better loan next time.”

When it comes to payment terms, installment loans are the exact opposite of payday loans. Instead of having to make a massive payment in a short amount of time, installment loans offer you the chance to make regular, smaller payments over a much longer period.

Most installment loans will offer you a MUCH lower APR on your loan than a dangerous payday loan and also—unlike many payday loans—they won’t charge a sneaky prepayment penalty.

What’s a prepayment penalty? Law professor David Reiss (@REFinBlog) sums it up well: “Prepayment penalties come into play if the borrower repays all or part of a loan before the payment schedule that the borrower and lender had agreed upon when the loan was first made. In theory, they compensate the lender for the costs of making the loan in the first place and any decrease in interest payments that the lender would get as a result of early repayment. In practice, prepayment penalties can be a new profit center for lenders if the fees are set higher than the amounts actually lost by prepayment.”

A good installment lender will also report your payments to credit bureaus, so you can actually build up your credit and qualify for a better loan next time.

So which loan is right for you? 

If you know with 110% certainty that you’ll be able to pay off your loan, with all of the interest and fees, as soon as it is due, then a payday loan may be a workable option. But that’s not usually what happens. In fact, according to the Consumer Financial Protection Bureau, four out of five payday loan borrowers find themselves forced to rollover (extending the term of their loan at the cost of another round of fees and interest)1 and the average payday borrowers are in debt to their lender a stunning 200 days of the year.2 So remember, with a payday loan, the odds are never in your favor.

Installment loans are a safer option, especially if you find a lender who is willing to work out terms that fit for you. It’s also important that they have good customer service representatives so you can reach someone in advance if you’re ever worried you might miss a payment. Finally, make sure that there’s no prepayment fee and they report your payments to credit bureaus so you can get an even better loan next time.

The world of lending can certainly feel like a jungle. So always go with a trusted, reliable leader—rather than a dangerous predator running down easy prey.

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References
1 “CFPB Finds Four Out Of Five Payday Loans Are Rolled Over Or Renewed.” ConsumerFinance.gov March 25, 2014 https://www.consumerfinance.gov/about-us/newsroom/cfpb-finds-four-out-of-five-payday-loans-are-rolled-over-or-renewed/. Accessed 30 March 2017.

2 Morran, Chris. “The Average Payday loan Borrower Spends More Than Half The Year In Debt To Lender.” Consumerist. April 26, 2013. https://consumerist.com/2013/04/26/the-average-payday-loan-borrower-spends-more-than-half-the-year-in-debt-to-lender/. Accessed 23 March 2017.


Contributors

Maggie Germanois a Certified Financial Education Instructor and financial coach for women. Her mission is to give women the support and tools that they need to take control of their money, break the taboo of discussing debt and income, and achieve their goals and dreams. She does this through one-on-one financial coaching, monthly Money Circle gatherings, her weekly Money Monday newsletter, and speaking engagements. To learn more, or to schedule a free discovery call, visit maggiegermano.com.

David Reiss, is a professor at Brooklyn Law School and director of academic programs at the Center for Urban Business Entrepreneurship. He is the editor of REFinBlog.com, which tracks developments in the changing world of residential real estate finance.