Payday Loans vs Personal Loans: Let’s Break it Down
Inside Subprime: Nov 12, 2018
By Jessica Easto
Just type “I need money” into a search browser and a world of borrowing options will pop up. Some of these will be safe, and many will not. So how can you tell the difference?
If you’re going to borrow money, two options you may find yourself considering are payday loans and personal loans. They may sound similar—both are options when you need fast cash to pay for expenses—but their differences are vast.
A personal loan is a type of installment loan—one that has fixed terms that require you repay the loan in regular installments. (Compare this to a credit card, which has no fixed repayment terms.)
Personal loans may include:
- Installment loans
- Debt consolidation loans
- Open lines of credit
- Fixed-rate loans
- Variable rate loans
- and others
You usually borrow personal loans from a lending institution, such as a bank or credit union or highly respected online firm, and you can typically use the funds for anything you want. This is different from other types of loans—like auto loans—that require you to put the money toward something specific. People commonly use personal loans to pay for major one-time expenses such as home improvements, education, weddings, and consolidating credit card debt.
Technically, a payday loan is a type of personal loan. However, the primary provider of payday loans are brick-and-mortar or online lenders that only offer high-interest payday loans or “cash advances.” These are generally not traditional banks and credit unions. A payday lender is an often predatory business who profits by trapping borrowers in cycles of debt.
Like personal loans, payday loans come with fixed repayment terms, and you can put the money toward any number of expenses. However, payday loans are designed to get borrowers from one paycheck to the next. This means that the repayment terms are extremely short and that the loan amount is low (the average payday loan principal is only $350). Usually, you only get one pay period (for example, 14 days) to repay a payday loan, and the principal rarely exceeds $1,000. In other words, you can’t use payday loans for major expenses, as you might with personal loans.
Another key difference is interest rates. Both payday and personal loans usually (though not always) have fixed interest rates, or an interest rate that does not fluctuate over the life of a loan. Personal loans tend to have higher interest rates than those like mortgages, because mortgages are “secured”—or backed by collateral such as your home—while most personal loans are “unsecure,” or not backed by anything.
The interest rates of personal loans often depend on your credit score. If you have a poor credit score, you may not be eligible for a personal loan. If you have subprime credit, you may be able to get the loan, but at a higher interest rate. Payday loans don’t require credit checks. While this makes the loans easier to obtain, it comes at a cost: no opportunity to build credit and those exorbitantly high interest rates.
The extremely high interest rates of payday loans make them more expensive overall, and it’s the interest rate that gets borrowers into trouble if they cannot repay their debt on time. Most payday lenders allow you to “rollover” debt, which allows you to extend the term of your loan for additional fees. As the interest on your loan grows, it can be difficult to repay it, creating a debt trap.
Rates and terms of personal loans vary by lender and type of financial product and you always need to do your homework before borrowing money. But a rule you should always follow is to avoid predatory payday loans like your financial health depends on it.