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Personal loans vs. payday loans: How to choose & alternatives

Sometimes we need the assistance a temporary loan can provide in order to maintain cash flow. In this article we go over the details of personal loans vs. payday loans as well as alternatives.

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Personal loans and payday loans are similar in that they provide a lump sum of money that you can use for pretty much anything. Whether you need cash to stay afloat as you wait for your next paycheck, or you have an urgent medical bill, either of these loans may come in clutch.

You can even use a personal or payday loan for debt consolidation. As a bonus, the application process for both types of loan is often simple and straightforward. And once approved, you can have the money in your account in a few days – sometimes one business day.

But similar as they may be, personal loans and payday loans are quite different. For one, you typically get a larger loan amount with a personal loan compared to a payday loan. That’s despite payday loans generally having high interest rates and additional fees.

Ultimately, the best type of loan for you between the two options boils down to your financial situation; what you need and can qualify for at that particular moment. Having an understanding of the terms and eligibility requirements of each type of loan can help you choose one that works for you. That’s why this article addresses personal loans vs payday loans.

Key takeaways

  • Personal loans and payday loans are similar in that they both provide a lump sum of cash that you have to pay back with interest.
  • However, personal loans generally have larger amounts, lower interest rates, a longer repayment period, and slightly longer application process compared to payday loans.
  • While payday loans don’t require a credit check, their high interest rates are often prohibitive.
  • Apart from personal and payday loans, borrowers have other alternative sources of credit to choose from. These include credit cards, short-term loans, term loans and microloans from nonprofit organizations.

Personal loans vs. payday loans: What’s the difference?

The main differences between personal loans and payday loans revolve around their amount, interest rates, repayment terms, effect on credit score, application process, and collateral. Here’s a detailed breakdown of personal loans vs payday loans.

Loan amount

Although some personal loan providers will let you borrow as much as $100,000, most of them cap the maximum at $50,000. You can borrow any amount between $1,000 and $50,000. Payday loans, on the other hand, let you borrow a small amount of money – typically $500 or less.

Interest rate

Compared to payday loans, personal loans have significantly lower interest rates. If you have a good credit score you can get your hands on an annual percentage rate (APR) that dips into single digits. The same can’t be said about payday loans, whose APR goes as high as 400%. This high percentage is a result of high interest rates combined with additional loan fees and costs. Ultimately, it makes payday loans extremely costly to borrowers.

Payment terms

Lenders of personal loans typically require borrowers to pay back the loan with monthly installments. You can set up automatic monthly payments so that you don’t miss any installment.

As for payday loans, providers typically expect borrowers to repay the loan when they get their next paycheck. Depending on your agreement with the lender, they can automatically withdraw funds from your account.

A good number of borrowers who use payday loans are in the low-income bracket. And since this type of loan comes with high interest rates, users often find it hard to repay the entire loan with one paycheck. This means taking another paycheck loan to repay the pervious one, which causes a roll-over loan. The more this happens, the more the borrower gets trapped in a cycle of debt.

Maturity period

While personal loans have a longer maturity period of three to seven years, payday loans typically have to be repaid within two weeks or once the borrower gets their next paycheck. The longer maturity period of personal loans, combined with their lower interest rates, usually translate to lower (and fairly) affordable monthly payments.

Effect on credit

If you have a personal loan, making on-time monthly payments for it can improve your credit score. With a good credit score, you can qualify for better lending terms like lower interest rates and monthly payments. Needless to say, the opposite is also true. A lack of diligence in repaying a personal loan will hurt your credit score.

Payday loans work differently. Providers generally don’t report on-time payments, so the loan is unlikely to boost your credit score. However, they do report missed payments to credit bureaus, which means a payday loan can damage your credit score. A good rule of thumb is to regularly pull your credit report and check how each tradeline affects the overall score.

Application process

First things first, personal loans are available from banks, credit unions and some alternative or online lenders. A good number of these loan providers may let you prequalify. That’s good because it allows you to compare interest rates and repayment terms without running a hard credit check. This essentially means that you can compare various loan offers and products without hurting your credit score.

Once you find a loan you like, you can proceed to apply for it. Most personal loan lenders allow you to complete the application process online. But some – especially traditional banks and credit unions – may have provisions for in-person applications.

Regardless of the method you choose, make sure to have all the required documentation. These typically include your government-issued ID, pay stubs and bank statements. Once you submit the application, the lender will now do a hard credit check.

Applying for a payday loan is quite different. For one, these loans are granted by payday lenders. They typically don’t check credit. Thus, your credit history and credit score may not influence your eligibility. However, the loan provider might collect information about your bank account to determine your ability to repay the loan.

Collateral

While both personal loans and payday loans are considered unsecured debt, some providers of personal loans may require that you offer collateral1. Whether it’s a car, savings account or even home, the collateral reduces risk on the lender’s part. Payday loans very rarely require collateral, according to the Consumer Financial Protection Bureau2.

How personal loans work

When you take out a personal loan, the lender gives you a lump sum of cash that you have to pay back with interest. Repaying a personal loan typically involves making fixed monthly payments over a set period of time. This is what makes personal loans essentially installment loans.

While the maturity period varies from lender to lender and depending on the loan amount, personal loans generally have a repayment period of three to seven years. Every monthly installment you make goes to the principal amount as well as interest.

As you may have guessed a high annual percentage rate (APR) translates to higher monthly payments while a low APR lowers your monthly installments. As things stand, personal loan interest rates currently range from 4.49% to 35.99% (accurate as of March, 2022)3. Therefore, interest rates in the single digits are generally good in the current market.

Most personal loans are unsecured, which means that you don’t have to put up any collateral. This tends to increase risk to the lender. As a tradeoff, most personal loan providers often require a good credit score, low debt-to-income ratio and solid credit history.

They may also slap you with a high annual percentage rate (APR) to minimize risk. This is especially the case for borrowers with a high debt-to-income ratio and checkered credit report. But if you have good credit and a small debt load, you can easily get your hands on a personal loan with low APR.

Circling back to the issue of collateral: while many lenders offer unsecured personal loans, some provide secured loans. They may require you to put up a personal asset as security for the loan. This can be a car, savings account, retirement account or even home.

Whatever the case, putting up collateral may get you a low interest rate and affordable monthly payments. The risk is that if you default on the loan, the lender may seize your asset to recoup their money.

Overall, a personal loan is a great option to have in your back pocket for sorting out personal finance. Generally, there are no restrictions on how you may use the proceeds of a personal loan. Common uses include:

  • Debt consolidation
  • Credit card refinance
  • Meeting business expenses
  • Emergency cash
  • Home purchase and/or improvement
  • Medical bills
  • Wedding or vacation expenses
  • Car financing

How to apply for a personal loan

  1. Pull your credit report. When applying for a personal loan, you may want to start by pulling your credit report to check your credit score. This will give you an idea of the APR and lending terms to expect. Generally, a good credit history will get you favorable interest rates and lending terms.
  2. Prequalify for the loan. Personal loan providers will let you prequalify for a loan with a soft credit check. This will not affect your credit score. Make sure to run calculations based on the exact loan amount that you need. Don’t borrow too much because you’ll end up paying interest on money you didn’t need. At the same time, don’t borrow less than your financial situation requires.
  3. Compare loan offers. The benefit of prequalifying is that it lets you compare APRs. Ideally, you’ll want to choose a loan with the lowest interest rate because that one will have low monthly payments. But don’t forget to factor in loan fees and costs since those too may determine your monthly installments.
  4. Apply for the loan. Once you’ve picked a lender, you can go ahead and apply for a personal loan through their website.

The lender will run a hard credit check, which will temporarily lower your credit score.

Pros and cons of personal loans

There are several advantages and disadvantages of personal loans. Weighing the benefits against drawbacks will help you understand whether it’s the right type of loan for you.

Advantages of personal loans

  • Predictability: since personal loans are repaid in fixed monthly installments, you’ll always know how much to budget for each month.
  • May not need collateral: unsecured personal loans are generally popular compared to secured loans. They don’t need any collateral to get.
  • Lower interest rates. Personal loans often have lower interest rates compared to alternatives like payday and credit card loans.
  • Have many uses. Personal loan lenders typically don’t limit how you can use the money. This leaves your options open. You can use a personal loan for debt consolidation, or even to pay off a cash advance and/or pay down credit card debt. Beyond debt management, personal loans can help you buy high-cost items like a car or home. Additionally, you may use the cash to start or run a business, or to meet any financial emergencies like paying a hospital bill.

Disadvantages of personal loans

  • Can be costly. If you take out a bigger loan than you need, the interest on the loan may accumulate to the point of you struggling to make monthly payments. That’s how some borrowers end up in a cycle of debt. To make matters worse, failure to make payments will damage your credit score.
  • Collateral is jeopardized. If you opt for a secured loan, you risk losing any asset that you put up as collateral. Of course, your ability to keep the asset depends entirely on whether you can fully repay the loan.
  • Additional fees. They may have lower interest rates than credit card and payday loans, but personal loans can still be expensive. That’s because lenders typically charge 1% to 8% origination fee, which may be rolled into the loan.

Cash advance vs. personal loan

A cash advance is a short-term loan typically provided by credit card and charge card companies. It allows you to borrow a certain amount of money against your card. The maximum amount you can borrow is usually lower than your credit card’s limit. Make sure to check your credit card statement for your cash advance limit.

How does a cash advance work? When you take out a cash advance, you’re essentially borrowing money against the lines of credit on your credit card. In other words, the cash advance comes from your credit card company. you can withdraw the money at an ATM or visit your bank and request for the cash advance in person.

Either way, your credit card company will charge you an initial fee of between 3% and 5% of the cash advance amount. The ATM and bank will also charge a service fee on their end. And as you would expect, your card issuer may start charging interest immediately you get the cash advance. These charges often make cash advances quite costly – costlier than personal loans.

In fact, cash advances usually have higher interest rates and very short repayment terms compared to personal loans. On the upside, if you have a credit card, then you don’t need to apply for a cash advance from a new bank. Plus, they are quicker to get compared to personal loans, which makes them great if you need money immediately.

However, only choose a cash advance over a personal loan if you’re able to pay off the advance quickly. Otherwise, its high interest rate and short repayment period can easily lock you in a cycle of debt.

On the other hand, a personal loan is better than a cash advance if you have a good credit score and don’t want to apply for a credit card.

How payday loans work

Payday loans work more or less like cash advances. Essentially, a lender grants you a short-term loan that carries a small amount of money – typically $500 or less – which you have to pay back within two weeks or on your next payday.

In addition to the principal amount, payday loan borrowers are typically expected to pay interest and a fee. The fee is often charged per $100 borrowed. While a fee of $15 per $100 is common, some lenders charge more (up to $30) while others charge less ($10). It boils down to their loan terms and the state law regarding maximum amount of payday loans4.

There are two ways to pay back a payday loan provider. First, you can grant them permission to automatically deduct the amount owed from your bank account on your next payday. Secondly, you may give them a postdated check.

Perhaps the biggest draw to payday loans is that they don’t require a credit check. You can get this short-term loan if you have bad credit, which makes them viable sources of personal finance for people with all kinds of credit quality.

Why payday loans can be dangerous

Payday loans are quite popular among low-income individuals. And that’s where the danger lies. Some users of these short-term loans are often unable to pay the full amount with their next paycheck. When this happens, the lender rolls over the existing loan into a new loan, which typically comes with new fees and charges. When combined with interest, these new costs increase the amount owed by a big margin.

Say, for example, that you take out a $200 payday loan with a fee of $15 per $100 borrowed and payment period of 2 weeks. Further, assume that you fail to repay the loan and are forced to roll it over for 10 weeks. This is how it will play out:

Principal $200

Loan fee $30 ($15 per $100)

Repayment period 2 weeks

Times rolled over 4

Total repayment period 10 weeks

Total fees payable $150

Total cost of loan $350

Many people are usually forced to take another payday loan to try and pay down the existing one. In doing so, they end up taking on more debt than they can pay. That explains why 58% of Americans who use payday loans are unable to meet their monthly expenses, and only 14% actually manage to pay back the loan5.

Ultimately, the habit of rolling over payday loans is what traps some Americans in the cycle of debt. If you default on a payday loan, the lender has legal rights to report you to credit bureaus, take you to court, and/or send your debt for collections.

One way to get yourself out of the cycle of debt is to do a payday debt consolidation. If you find that you keep rolling over payday loans, consider taking out a personal loan or a 401(k) loan and using the proceeds to pay off all existing payday loans.

That will leave you with just one loan to worry about. And if it’s a personal loan, then you’ll like get significantly lower interest rates and fixed monthly payments, which are far more predictable than payday loan payments.

Payday loan interest rates by state

Payday loans are at times known as “predatory loans” because of their sky-high interest rates and the fact that they “prey” on low-income borrowers who are desperate to make ends meet. In Texas, for example, the average rate for these loans currently stands at 664%. That’s an unbelievably high rate by any measure, which explains why some American states have a 36% cap on payday loan interest rates. These states are:

  • Arkansas
  • Arizona
  • Colorado
  • Connecticut
  • D.C.
  • Georgia
  • Maryland
  • Massachusetts
  • Montana
  • Nebraska
  • New Hampshire
  • New Jersey
  • New York
  • Oregon
  • North Carolina
  • Pennsylvania
  • South Dakota
  • Vermont
  • West Virginia

In addition to capping the maximum interest rate at 36%, Oregon has additional legislation around payday loans. Providers are mandated to give borrowers at least 31 days to repay the loan. Additionally, lenders can only charge a one-time origination fee of 10%, and a maximum of $30 for a new loan6.

Below is a look at other states that have SOME legislation regarding payday loans:

Maine

This is one of the states where payday loans are heavily regulated. The state doesn’t permit payday loans, unless the “lender is fully licensed and supervised”7. Furthermore, the maximum amount that a payday loan lender can offer is $2,000. If a borrower takes out this amount, the maximum annual percentage rate they can be charged is 30%. Otherwise, the lender may charge a higher APR for a lower amount. This is why the current average APR in Maine is 217%. Loan charges depend on the amount borrowed. Lenders can charge $5 for amounts up to $75, $15 for amounts between $75 & 250, and $25 for any amounts above $250.

New Mexico

Payday loans are completely prohibited in New Mexico. Lenders are only allowed to offer small cash loans of up to $5,000, and even those have an interest rate cap of 175%. Additionally, borrowers have a 120-day repayment period and are legally allowed at least four repayments (installments)8.

Ohio

With a 28% cap on annual percentage rates, Ohio has one of the most favorable APRs on payday loans. Lenders are further required to give a repayment period of between 91 days and 1 year. The payday loan limit in Ohio is currently pegged at $1,000. And while users are allowed to borrow payday loans from multiple providers, they must not exceed a total debt of $2,5009.

Oklahoma

While payday loans are legal in Oklahoma, the Oklahoma Small Lenders Act (enacted in 2020) caps the maximum loan amount at $1,500 and monthly interest rate at 17%. Furthermore, finance charges must not exceed 20% of the borrower’s monthly income10.

Virginia

Virginia’s HB 789, which was enacted in 2020, changed the term “payday loans” to “short-term loans”. Under this bill, loan lenders can grant a maximum of $2,500 with a maximum annual percentage rate of 36%. The law also introduced a minimum repayment period of four months and a maximum of 24 months11.

Washington

Under the Wash. Rev. Code Ann. 31.45.010 et seq. (specifically Chapter 31.45 RCW – Check Cashers and Sellers), payday lenders operating in Washington must have a state-issued license. This includes online lenders from out of state. As far as limits, the maximum loan amount is $700 or 30% of a borrower’s gross monthly income. The maximum loan term is 45 days12.

Apart from the aforementioned, other American states do not have legislation about payday loans, particularly around APR. Loan lenders and the market largely determine what to charge based on factors like borrowers’ income and debt-to-income ratio. Here’s a chart of payday loan interest rates by state.

Source: CNBC

How to apply for a payday loan

Compared to personal loans, payday loans are quite easy to qualify for. As the Consumer Financial Protection Bureau reports, payday lenders just require an active checking account, proof of income, and a valid ID that proves you’re above 18 years old13.

If you decide to apply in person, you could walk out with cash from the lender within minutes14. Your only task would be finding a payday loan provider in your area. Online lenders may take up to one business day to send the money to your checking account. Regardless of how you choose to apply for it, a payday loan is definitely one of the easiest to access and fastest to get.

Pros and cons of payday loans

On the one hand, payday loans are among the easiest to qualify for. You don’t even need good credit to get approved. On the other hand, the high interest rates that lenders charge on these short-term loans make them costly. Plus, a lender may send your debt to collections within 60 days15 of frequently rolling it over. So, while they do have their benefits, payday loans also come with some considerations. Below are their pros and cons.

Advantages of payday loans

  • No credit check. Payday loan lenders don’t check borrowers’ credit when determining eligibility. This is because the loan is secured by the borrower’s next paycheck. Therefore, you can qualify even if you have bad credit.
  • Short time to funding. When you apply for a payday loan in person, you may get the cash almost instantly. Online lenders typically take one business day.
  • No limits on spending. You can use a payday loan for virtually anything. Whether it’s paying a bill or paying down a credit card, these loans may help you make ends meet.
  • Various types to choose from. Payday loan providers offer check-advance loans, cash-advance loans, deferred-deposit loans, and post-dated check loans. You can choose whichever one works best for you from the available options.

Disadvantages of payday loans

  • High interest rates. The annual percentage rate on payday loans rises to over 600% in some states. Frequently rolling over the loan could see you pay an amount manyfold what you borrowed. This may lock you in the vicious cycle of debt.
  • Risk of overdraft charges. As mentioned, one way of paying back a payday loan is via an automatic withdrawal from your checking account. If you don’t have enough money that checking account on the due date of the loan, you may get an overdraft charge.
  • Short repayment terms. The typical maturity period of a payday loan is two weeks or on your next payday. Many borrowers usually fail to raise the full amount owed within this period.

Which loan should I choose?

Overall, payday loans seem attractive at first glance mainly because they are easy to get. However, their high interest rates – coupled with lenders’ relentlessness in collection – make them costly and risky. Only use them as the last resort when you can’t qualify for a personal loan or any other type of loan for that matter.

Personal loans typically have lower interest rates compared to payday loans, which makes them more affordable. You can get an even lower rate if you have a good credit history. For this reason, they generally make more financial sense compared to payday loans.

That said, the choice between personal loans vs payday loans really comes down to what you can qualify for and pay back comfortably. If your credit report is checkered and your debt-to-income ratio is high, most banks and credit unions will be unwilling to offer a personal loan. In which case you may need to rely on a payday loan.

You also have the choice to use a payday loan as a bridge loan as you wait for a personal loan to be disbursed in your checking account. This may be necessary because some banks and credit unions take longer to process personal loan requests. In case you’re really pressed for cash, a payday loan can fill the gap as you wait.

The bottom line is that there’s no right or wrong type of loan. It’s a question of what you qualify for and what you can pay back. You can even use both if it makes financial sense. Just make sure that you don’t sink in debt. And if you feel that neither option is viable, then you’ll be glad to know that there are several alternatives to explore, especially if you’re a business owner.

Alternative loan types

  • Credit card – this is a revolving loan that allows you to pay for purchases on credit and repay slowly by making minimum monthly payments.
  • Line of credit – similar to a credit card, a line of credit gives you cash than you can spend and repay later. You’ll often be required to make minimum monthly payments. The main differences between a credit card and line of credit include the fact that the latter provides cash while a credit card typically pays for purchases.
  • Short-term business loan – often provided by banks, credit unions and online lenders, these are business loans with a maturity period of one to two years. Loan amounts typically max out at $500,000.
  • Term loan – a term loan typically has a larger loan amount compared to a short-term loan (up to $2 million). While it’s mostly provided by banks and credit unions, some online lenders may also have it in their product lines.
  • Equipment financing – if all you need is to purchase, upgrade or repair equipment or machinery, you may look at getting an equipment loan over a personal or payday loan. Equipment financing is offered specifically for acquiring or upgrading tools, machinery and equipment.
  • SBA loan – the U.S. Small Business Administration offers a wide array of business loans, including the SBA 7(a) and SBA 504. Both have maximum loan amounts of $5 million, which makes them great for startups and high-cost investments (like opening a new location).
  • Microloans – the SBA and some nonprofit lenders like Accion offer small business microloans. A microloan is basically a loan with a small amount of money – typically $50,000. Depending on the lender you approach, a microloan may be easy to qualify for because not all lenders check credit or consider revenue and time in business.

References

1. Experian

Link: https://www.experian.com/blogs/ask-experian/what-can-be-used-as-collateral-for-a-personal-loan/

2. Consumer Finance Protection Bureau

Link: https://www.consumerfinance.gov/ask-cfpb/do-i-have-to-put-up-something-as-collateral-for-a-payday-loan-en-1595/

3. NerdWallet

Link: https://www.nerdwallet.com/best/loans/personal-loans/personal-loan-interest-rates

4. Consumer Finance Protection Bureau

Link: https://www.consumerfinance.gov/ask-cfpb/what-are-the-costs-and-fees-for-a-payday-loan-en-1589/

5. Credit Summit

Link: https://www.mycreditsummit.com/payday-loan-debt-statistics/

6. Oregon.gov

Link: https://dfr.oregon.gov/financial/loans/personal/payday/Pages/index.aspx

7. ustatesloans.org

Link: https://www.ustatesloans.org/law/me/

8. ustatesloans.org

Link: https://www.ustatesloans.org/law/nm/

9. ustatesloans.org

Link: https://www.ustatesloans.org/law/oh/

10. ustatesloans.org

Link: https://www.ustatesloans.org/law/ok/

11. ustatesloans.org

Link: https://www.ustatesloans.org/law/va/

12. ustatesloans.org

Link: https://www.ustatesloans.org/law/wa/

13. Consumer Finance Protection Bureau

Link: https://www.consumerfinance.gov/ask-cfpb/what-do-i-need-to-qualify-for-a-payday-loan-en-1593/

14. Upstart

Link: https://www.upstart.com/blog/personal-loans-vs-payday-loans-which-is-better

15. Experian

Link: https://www.experian.com/blogs/ask-experian/what-if-i-cant-pay-back-a-payday-loan/

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