Personal Loan vs. Payday Loan: What’s the Difference?
On the surface, personal loans and payday loans seem similar. After all, both of these financial products can be used to fund virtually any purpose, and you’ll receive the money in one lump-sum payment if you’re approved.
However, that’s where the similarities end. Once you start reading the fine print, these two types of loans could not be more different. Here’s a look at what you need to know about the key differences between the two.
Personal loans vs. payday loans: At a glance
| Personal loans | Payday loans | |
|---|---|---|
| Loan amounts | Typically $1,000 to $100,000 | Typically $100 to $1,000 |
| Loan length | Generally 1 to 5 years | Generally about two weeks |
| APR | Typically 6% to 36% APR | Typically 400% APR |
| Credit check | Yes | No |
Loan amounts
Personal loans typically come with much higher loan amounts than payday loans. While each lender will set its own loan limits, most personal loan lenders let you borrow between $1,000 and $100,000. (Although, it’s worth noting that if you want to keep your borrowing amount low, small personal loans exist.)
Meanwhile, payday loan amounts are typically much smaller. You can typically only borrow up to $1,000 with a payday loan.
Loan terms
The loan term, or the amount of time for which you can borrow money, is also different between the two. For their part, personal loans usually give you several years to repay the funds. One to five years is fairly common. However, it’s possible to find lenders that offer long-term personal loans if you need more time to pay down your balance.
You’ll generally be expected to repay a payday loan much quicker. The average loan term on a payday loan is about two weeks.
Interest rates
Perhaps the biggest difference between personal loans and payday loans is their respective interest rates. Personal loans typically charge a rate between 6% and 36% APR, based on the strength of your credit score. Financial experts generally believe any annual percentage rate (APR) above 36% is considered predatory lending.
In contrast, payday loans typically have much higher interest rates. The average rate on a payday loan can meet or exceed 400% APR. That amounts to about $15 to $30 in interest charges for every $100 borrowed.
Ability to build credit
Another major benefit of personal loans is that they report information on all of your payments to the credit bureaus. With that in mind, if you work to build a history of on-time payments, taking out a personal loan can actually help you improve your credit score. By the same token, though, missing payments can negatively impact your score.
Payday loan lenders, on the other hand, generally won’t report to the credit bureaus, so paying them back on time won’t necessarily help build your score. However, if you have a history of missed payments, they will likely send the debt to collections, which can cause your score to drop significantly.
Loan applications
Many banks, credit unions and online lenders offer personal loans. In many cases, you’ll be given the opportunity to prequalify for a loan, which will give you the ability to gather multiple loan offers and shop around for the best rate without impacting your credit.
Once you’ve decided on a lender, you’ll formally apply for the loan. This step will require you to fill out an application with information about you, your finances and the loan you’re hoping to borrow. Then, you’ll be asked to submit supporting documentation, such as pay stubs, and to allow the lender to do a hard credit pull before being given an approval decision.
These extra steps are meant to ensure that you’re financially capable of repaying the loan. They’re used to reduce the risk of you defaulting on the loan, which can be a hardship for both you and the lender.
For the most part, payday loan lenders don’t do any due diligence to ensure you’re comfortably able to repay the loan. They will likely ask you to fill out an application that includes your banking details so they’re able to access funds for repayment. But they typically won’t perform a credit check or ask for much additional supplemental documentation beyond proof of income.
Loan repayments
Repaying a personal loan usually involves making a series of fixed installment payments on a monthly basis. While many lenders offer the opportunity to set up automatic payments, which allow the money to be automatically drawn from your account, this payment method is typically optional and may even result in an interest rate discount.
Payday loans are traditionally paid back in one lump-sum payment. That payment is usually due around the time of your next paycheck. If you’ve provided your banking details, your lender will likely automatically withdraw the funds from your account.
The payday loan debt cycle
How does a personal loan work?
Once you’re approved for a personal loan, a lender gives you funds in a lump-sum payment. With a fast loan, you could even get funding within 24 hours. You’ll be expected to repay that amount, plus interest, over a series of fixed monthly installments. These recurring payments will typically last for a few years until the loan is repaid in full.
Here’s an example of how your monthly payments could look, using hypothetical numbers:
Cost of a personal loan
| Loan amount | $10,000 |
| Credit score | 720-759 |
| APR | 16% |
| Repayment period | 60 months |
| Monthly payment | $243.18 |
| Interest paid | $4,590.83 |
Personal loans are most commonly seen as a form of unsecured debt, which means you likely won’t be required to put up collateral in order to be approved. However, as a result, these loans are thought to be riskier for the lender, so they may come with higher interest rates and stricter qualifying standards. Unsecured personal loan lenders traditionally rely heavily on financial factors like your credit score and debt-to-income ratio to determine your eligibility and APR.
If you have a lower credit score, you may want to consider a secured personal loan. Secured loans are attached to an asset, which can be repossessed by the lender if you fall behind on your payments. Since these loans are less risky for the lender, they often come with lower interest rates and more lenient qualifying standards. Still, it’s important to be aware that you risk losing an asset if you’re unable to make payments on the loan.
Pros and cons of a personal loan
Personal loan funds can be used for virtually anything: You can use a personal loan to finance anything from medical debt to home improvement expenses or wedding costs. Personal loan payments are fixed: Fixed payments are easier to budget around and can help prevent surprises since your monthly payment will always stay the same. Personal loan payments don’t always require collateral: You may not have to put an asset at risk in order to be approved for a loan. | Personal loans can have high interest rates, too: Particularly if you have bad credit, the APRs on personal loans can get high, which will add more to your total cost of borrowing. Personal loans come with some risk: If you can’t afford to repay the loan, you risk damaging your credit score, as well as losing an asset if the loan is secured. Personal loans may have high fees attached: Many lenders will charge origination fees to cover the administrative costs of generating a new loan. Some will also charge late payment fees if you make a payment after your due date. |
Applying for a personal loan
In most cases, applying for a personal loan is as simple as following the steps below:
1. Estimate your need: First, figure out how much you’ll need to borrow. If you’re borrowing money to cover a smaller, fixed cost, the answer may be obvious. But, larger expenses may require you to get estimates to figure out your loan amount.
2. Check your credit score: Since each lender sets its own eligibility criteria, checking your credit score ahead of time can help boost your odds of getting approved for a loan.
3. Shop around for a loan: Interest rates can vary widely between lenders, so it’s a good idea to gather loan estimates from multiple lenders before making your final decision. Just be sure to give each lender the same information so that you can truly make an apples-to-apples comparison once you have your loan offers in hand.
4. Apply for the loan: Once you’ve decided on a lender, it’s time to fill out your loan application and submit any supplemental documentation so that the lender can make its approval decision.
5. Close on the loan: After you’ve received loan approval, read over the loan agreement. If everything seems agreeable to you, you’ll sign all the paperwork and the funds will be disbursed to you.
How does a payday loan work?
At their core, payday loans are small amounts that can be funded quickly without the borrower having to agree to a credit check. Loan repayment is typically due at the same time that the borrower receives their next paycheck, with the repayment funds and fees being automatically withdrawn from their account.
In exchange for their more lenient qualifying standards, these loans typically come with much higher APRs than personal loans, which typically range from $10 to $30 for every $100 borrowed. As a result, it’s easy for borrowers to get caught up in a cycle of debt, where they have to take out a new payday loan in order to pay off their old one in addition to covering their other monthly expenses.
Pros and cons of a payday loan
Payday loans don’t require a credit check: Since these loans are backed by funds from your next paycheck, lenders typically don’t require you to undergo a credit check for approval. Payday loans offer access to fast funding: Since payday loan lenders do little due diligence to determine whether you can afford to pay back the loan, their funding times are often faster than some traditional lenders. Payday loan funds have few use restrictions: You can use the funds from a payday loan to finance virtually any expense, including paying bills if you are in a pinch and need to make ends meet. | Payday loans can have sky-high interest rates: Although payday lenders typically advertise their fees as an amount per $100 borrowed, when you compare the numbers, their APRs typically easily exceed 100%. Payday loans have short loan terms: You’ll be expected to repay a payday loan at the time of your next paycheck, which is typically about a two-week timeframe. Some borrowers may not be able to come up with the funds to cover the loan amount plus fees in that time. Payday loans can start a cycle of debt: If you need to rollover your payday loan because you can’t pay it off in time, you may find yourself building up an amount of debt that is hard to pay down. |
What happens if you don’t pay back a payday loan?
Payday loan lenders will automatically withdraw the funds from your account on the day that your loan becomes due. They will do this either by depositing a post-dated check or through an electronic transfer if you’ve provided them with your banking details.
If there aren’t enough funds in your account when the withdrawal takes place, the payday loan lender is still entitled to the funds they are owed. They may send your debt to collections or even sue you for payment.
How to escape the payday loan cycle of debt
Borrowing a payday loan may be easy, but repaying it isn’t always as simple. Because these loans typically have such short terms, borrowers can often have trouble paying them back in time.
If you can’t afford to repay your payday loan, taking out a personal loan to cover the costs is always an option. This will allow you to repay your balance over the course of several monthly installments instead of having to worry about repaying the full balance in one payment. When you have more than one payday loan, a debt consolidation loan is also a useful tool that can help you streamline multiple debt payments into one.
On the other hand, if you think you may need professional assistance to get out of debt, consider credit counseling. Counselors registered with the National Foundation for Credit Counseling (NFCC) can help you learn the skills you need to better manage your money and debts.
Alternatives to a payday loan
Borrowing money can be difficult, especially if you have bad credit or no credit at all. But, that still doesn’t mean a payday loan is your only option. If you need money in a pinch, consider one of these payday loan alternatives:
- Choose a paycheck advance app: Similar to payday loans, paycheck advance apps let you borrow money against your next paycheck. However, these apps don’t usually charge fees and interest. The catch is, though, that the money is still automatically withdrawn from your account, so you could risk racking up fees if you overdraft.
- Use a secured loan: Secured loans are backed by collateral, which makes them easier to qualify for than traditional personal loans. However, since they’re attached to an asset, you risk having that asset repossessed if you can’t keep up with your payments.
- Choose a payday alternative loan (PAL): PALs are small loans offered through credit unions. They’re worth up to $2,000 and have a max APR of 28%. Not all credit unions offer them, but when available, they can be a viable alternative to high-cost payday loans.
- Ask friends and family for help: While this isn’t an option for everyone, you could consider asking your loved ones for assistance. If you decide to go this route, consider creating a personal loan agreement so that everyone is on the same page about what’s involved in the borrowing arrangement.