Installment Loans vs Payday Loans: Let’s Break it Down
Inside Subprime: Nov 26, 2018
By Jessica Easto
More than 16 million Americans have personal loans. The collective balance of those personal loans rose to $107 billion this year—an all-time high. People take out personal loans for all types of reasons, from one-time emergency expenses, like unforeseen medical costs, to long-term investments, like a home remodeling project. Any time a person can’t pay cash in full for an expense, borrowing money from a lender is an option.
There are several types of personal loans that serve different purposes. In this article, we will examine the differences between two common types of personal loans: installment loans and payday loans.
So what’s the difference between these two loan types? Are installment loans cheaper? Are payday loans safe? (Spoilers: No, payday loans are not safe.)
For starters, installment loans and payday loans are structured very differently. Installment loans are generally designed to be repaid over a long period of time (i.e., longer than six months) via scheduled, recurring, equal payments. These payments generally occur on a monthly basis. The installment structure is a common one. You’ll see it used with many types of loans, including:
On the other hand, traditional payday loans are, allegedly, designed to be repaid quickly, usually within two weeks, in a single, lump-sum payment that occurs when you receive your next pay check. (why do we say allegedly? Because payday loans aren’t actually intended to be repaid. They’re designed to trap borrowers in cycles of debt. More on that later.) You usually have to provide a payday loan firm with a postdated check at the time you receive the loan, so they can immediately cash it on payday.
The differences in the length of the loans’ repayment terms are related to the differences in the loans’ value. Installment loans tend to be for larger sums of money than payday loans. The principal of a payday loan is usually less than $1,000 while the principal of an installment loan is generally more than $1,000—and can be tens of thousands of dollars, especially for mortgages.
Although the installment loan’s principal is higher, the payments are generally affordable because the repayment term is longer—as long as 30 years in the case of a mortgage. The longer the repayment term, the smaller the regularly scheduled payments are.
However, a longer repayment period means that compound interest has more time to accrue, even if you are paying a small, affordable amount of interest with each payment (called amortization). Theoretically, you would pay more in interest with an installment loan than a payday loan, but there are other factors to consider, including each loan’s APR.
A loan’s annual percentage rate, or APR, describes how much the loan will cost a borrower over the course of one year. It accounts for the principal as well as any other fees or charges. APRs for installment loans vary based on the type of loan it is and other factors, such as your credit score. For example, the average APR for a mortgage is around 5 percent while the average APR of a private student loan is around 7 to 9 percent.
Still, the typical APR for an installment loan is much lower than the typical APR for a payday loan, which can be as high as 400 percent. These high APRs combined with the short repayment term of payday loans often make it difficult or impossible for borrowers to repay. When that happens, borrowers may have the option to “rollover” the loan—for additional fees, of course, which digs the borrower further into debt. Payday lenders also have a tendency to obscure information, making it difficult for borrowers to fully understand the commitment of the loan when they sign on the dotted line. This type of predatory lending is rampant in the United States, where payday loans are still legal in most states.
By comparison, installment loans are one of the safest ways to borrow money, and when you make payments on time, they actually help you improve your credit.
The bottom line: Installment loans are safer, higher-dollar and longer term than predatory payday loans which are simply traps designed to pray on the financially vulnerable.