Personal loans and payday loans are both used to pay for expenses or purchases that you might not otherwise be able to afford.
It's sometimes hard to predict when a sudden need for cash will arise. At other times, you may have plenty of advance warning say, for an upcoming bar mitzvah, honeymoon or world cruise.
Personal loans and payday loans represent 2 very different approaches to obtaining extra cash in terms of loan size, loan period, cost and qualifications.
In this GET.com guide, we'll help you understand the differences between personal loans and payday loans.
A personal loan from a bank is unlike a mortgage or car loan in that it does not require any collateral (house or car), so in the event you do not pay back the loan, the bank cannot directly seize your assets.
Personal loans typically take days to process. You need provide documents such as pay stubs, bank accounts, tax returns and so on. The bank also evaluates your credit score, income, expenses, wealth and other factors.
Currently, personal bank loans typically charge from 12 to 30%, although higher and lower rates are available, depending on your credit score and other factors.
Personal loans may have terms of months or years.
- Lower interest rates: Personal loans have much lower interest rates compared to payday loans, so they are a good option for when you need some handy cash.
- Consolidate your credit card debt: Personal loans can be used to consolidate your credit card debt since personal loans usually charge lower interest rates than credit cards. Using a personal bank loan for this purpose will help you pay off your debt faster.
- May have higher interest rates than some credit cards: This depends on your credit score. If you are looking for extra cash to make big purchases, you're better off with a credit card that offers a 0% introductory APR on purchases for a specific period of time.
- Slightly longer approval process: Because the personal loan provider needs to evaluate all your submitted documents, it usually takes several days for your personal loan to be approved.
Payday loans are high-interest, short-term loans that normally must be repaid on your next payday. They are meant to help employed people bridge temporary cash shortages. Payday lenders evaluate a borrower's employment, bank account and income to set an initial credit limit, which can rise over time if the borrower maintains a good record with the lender.
As with personal bank loans, borrowers do not need a good credit rating or collateral to secure a payday loan.
For those with a bad or non-existent credit rating (victims of bankruptcy for example), a payday cash advance can be a viable solution, because whether you get it depends only on your current circumstances rather than your entire credit history.
To obtain a payday loan, you fill out an application if you meet certain standard requirements. For example, in the US, typical requirements state that borrowers must be a US resident, be at least 18 years old, have a paying job, have a valid US bank account, and have wages paid directly into a bank account.
The lender discloses the amount of the loan it will make and the interest rate it will charge. The initial loan amount might be $100, $500, $1,000 or more, depending on the borrower's circumstances. The due date extends to the borrower's next pay date, normally up to 30 days.
The borrower can pay back the loan on or before the due date, or roll over the loan. A rollover delays the repayment date for an additional pay period, although a rollover fee must be paid on the due date.
According to the Federal Trade Commission, payday-loan APRs have exceeded 390% in some states! Payday costs can mount quickly if a loan isn't paid back on time, so never get this type of loan if you aren't 100% sure you can pay it back by the due date.
- No credit history needed: You can get a payday loan even if you don't have a credit history.
- Loan amount can be small: You can get a payday loan of just a few hundred bucks whereas personal loan amounts are usually higher.
- Significantly higher interest rates: According to a 2014 research by the Consumer Financial Protection Bureau (CFPB), people who take out an initial payday loan and 6 renewals will have paid more in interest than what the original loan amount was worth. The average interest paid on a payday loan is 15%.
- You can become trapped in a cycle of debt: Once you get a payday loan, you are more likely to get additional loans from the lender. Over 60% of payday loans are made to borrowers in the course of loan sequences lasting 7 or more loans in a row. When you get additional loans or renew your loans, the interest rate can top 1,000%!
Personal loans are always cheaper than payday loans. In fact, they are preferable to payday loans.
Personal loans are appropriate if you have good credit, need a substantial amount of money and can afford to repay the loan in monthly installments.
A payday loan is very expensive, but may be the only recourse if you have poor or no credit history or need money in a hurry. Care must be taken to not allow a payday loan to snowball in size by constantly renewing it. The odds are against a payday loan borrower, so try to avoid it at all costs, if possible!
If you aren't under time pressure, a credit card with a long, introductory low-interest period might be a better choice than either a personal loan or a payday loan, because you can even get a 0% interest rate.
Typically, good low-interest credit cards offer at least 12 months of 0% APR on purchases, starting from the time you sign up for your card. Some offer introductory periods of as long as 18 months.
That makes them a good short-term solution, since you can get credit and pay it back as many times as you like within the introductory period. You just have to make the minimum payment every month, and this is a very small percentage of the amount you borrow.
The downside is that, for one, after the introductory APR period is over you will get a high APR (though this may not be much higher than average payday loan APRs). You also will not be able to get a very high line of credit, especially if you don't have excellent credit.
Credit cards for poor or fair credit often don't have long introductory APRs, so they won't completely take the place of payday loans for those with bad credit.