Personal Loans

Personal Loan vs. Payday Loan

Few things in life are more stressful than being hit with an unexpected expense and not being able to cover it. Your car died and you need to get it fixed right away; a medical emergency has you inundated with bills; your spouse was laid off suddenly and the loss of income causes you to fall short of this month’s rent — any one of these scenarios can be catastrophic.

When you’re faced with an urgent expense, your instinct may be to borrow money wherever you can get it, no matter the interest rate or long-term cost. But the decisions you make in those high-stress situations can have a long-term impact on your financial well-being.

Personal loans vs. Payday loans: Key differences

When you need money quickly, you may decide to take out a personal or payday loan to cover your expenses. In both cases, you can secure money relatively quickly without leveraging assets (such as your house or car) to receive the loan. But there are important differences between the two, particularly in the interest rates and repayment periods.

Personal loans are issued by a range of different lenders, including banks, credit unions, financing companies, and online lenders. Lenders will use your credit score and credit history to underwrite the loan, using that data to determine how much you can borrow and at what interest rate. Bruce McClary, vice president of communications at the National Foundation for Credit Counseling, noted that banks and credit unions typically offer the best rates.

Borrowers with poor credit scores (579 and below) may not be eligible for personal loans. Those with subprime credit (scores between 580 and 669) may be approved, but receive higher interest rates. From the borrowers’ perspective, borrowers with subprime and poor credit represent significant risks, which is why they may deny them a loan application or charge higher interest.

The criteria for payday loans are much less stringent, and showing a pay stub or other form proving your income is usually enough to be approved. However, payday loans carry extremely high-interest rates, often carrying annual percentage rates (APRs) of 400 percent or more.

Differences Between Personal Loans and Payday Loans
  Typical amount borrowed Typical cost of borrowing Typical repayment period Requirements to qualify
Personal loan $1,000 to $50,000 About 6% to 35% interest 2 to 5 years credit check, proof of income, bank account, identification
Payday loan $500 $10 to $30 interest per $100 borrowed 2 weeks proof of income, bank account, identification

*Loan and interest rate amounts may vary based on borrower’s circumstances and lender’s terms

Personal loans: A deep dive

Unsecured personal loans, also known as signature loans, are loans that are not collateralized by other assets. They can be useful for obtaining money quickly to cover a range of expenses.

If you’re currently struggling with high-interest debts, for example, you can use a lower-interest personal loan to consolidate and pay those off. You can also use personal loans to cover sudden expenses such as car repairs, hospital bills, and replacing major appliances such as a furnace or refrigerator that went bust in the middle of the night.

Pros

Your choice of a repayment term: Lenders usually offer some flexibility in the length of the loan offered, so you can create a repayment schedule that won’t overwhelm you each month.

Fixed rates: Unsecured loans are generally fixed-rate loans, making it easy to plan your monthly expenses.

You may be able to get a cosigner: A cosigner could help you qualify for a personal loan with favorable rates. You might consider asking a trusted family member or friend to cosign the loan for you. Cosigning essentially means that they’re vouching for you by using their good credit score and financial profile to guarantee the loan. They’re responsible if you don’t honor your repayment agreement, so it’s important to discuss the risks with them and be sure that you can meet your obligations.

Repayment can improve your credit: Lenders typically report your payment history to the credit bureaus. With on-time payments, your credit may improve over time, allowing you to qualify for better terms in the future.

Cons

Tougher qualification requirements: Although personal loans can be used strategically, they’re not a cure-all for your financial woes. Since unsecured loans aren’t backed by other assets, lenders take on higher risks when issuing them, and that usually means stricter qualification requirements. But if you have strong credit, you may be able to secure a personal loan at a favorable rate.

Potentially high interest rates: With an unsecured personal loan, the lowest rates are reserved for borrowers with the highest credit scores. Some borrowers, for example, may only qualify for triple-digit rates. That means if you have poor or just OK credit, you may be better off using a credit card. Be sure to get preapproved for a personal loan before committing. That way, you can get a preview of the rates you may qualify for.

How to find a personal loan

Finding the best offer is essential when taking out a personal loan, especially when you need the money for an urgent expense. Here are some steps you can take to prepare for the loan application process and ensure that you choose the right lender:

1. Check your credit score

Knowing your credit score will help you gauge the likelihood that you’ll qualify for a loan, though you should still talk to a lender even if your score isn’t on the higher end. If you have a relationship with a bank or credit union, they may be willing to work with you, particularly if you can prove that you’re creditworthy based on past accounts or other debts that are in good standing.

2. Make a checklist

There are several different factors to consider when evaluating a loan offer. Create a list of the key elements you’ll want to research, including:

  • Interest rate
  • Loan origination and closing fees
  • APR
  • Loan terms (fixed or variable rate)
  • Repayment period
  • Prepayment penalties

Tracking all of these variables will help you make an informed decision about which product and lender to choose.

3. Compare lenders

Banks and credit unions offer personal loans but consider financing companies and online lenders as well. It’s important to shop around so you know who is offering the best overall product. One company might advertise lower interest rates, but the closing fees and other miscellaneous costs could offset that advantage.

When possible, speak with the lender directly. Getting a loan officer on the phone or in-person will allow you to ask questions and feel confident that you fully understand your potential obligation.

Payday loans: A deep dive

People often turn to payday loans when they need cash urgently and won’t receive another paycheck for a few weeks. Unlike personal loans, payday loans don’t require a credit check. As long as you have proof of income, identification, and a bank account, you’re likely to qualify for a loan.

Ellen Billie, programs director at the Fair Credit Foundation, said she often hears from clients that they have positive interactions with payday lenders, perhaps because there is less anxiety involved in getting approved: “It’s a lot nicer of a process than going in and being denied a loan at a traditional financial institution,” she said. “[There’s] no credit check, so they don’t have to be embarrassed about that if they have poor credit, and the money’s available immediately.”

But despite these apparent benefits, payday loans come with exorbitant fees that often make it impossible for people with low incomes and bad credit to pay off the debt. Borrowers will sometimes take another payday loan to pay off the first one. Before long, they have multiple high-interest loans and are overwhelmed by the debt.

“A lot of times, they can’t keep up with the payments, and so one $500 payday loan turns into three, and then they’re just in over the head and can’t get out of it, so their situation becomes a lot worse,” Billie said.

Pros

Low qualification requirements: Payday loans are easy to qualify for. The lower barriers to approval and immediate access to money make payday loans convenient, particularly in situations when you need cash right away. For borrowers who have low credit scores or bad credit histories, approaching a payday lender can be less stressful and emotionally taxing than applying for a loan through a bank or credit union.

Fast turnaround on funds: Once approved for a payday loan, you’ll receive the money immediately. Although payout structures can vary by lender, you may be able to accept the lump sum as cash, via prepaid debit cards, or a direct deposit to your bank account.

Cons

Extremely high rates and fees: Payday loans are considered predatory because they carry astronomical interest rates. The laws regulating payday lending and the interest charged vary by state, but you can likely expect to pay between $10 and $30 for every $100 you borrow. The Consumer Finance Protection Bureau notes that on a two-week loan that carries a $15 fee per $100 borrowed, you would pay 400 percent interest.

Potential caps on loan amounts: Payday loans are often made in the amount of $500, although different lenders may offer higher loan limits or borrowers may want to take less than that. Some states cap payday loan amounts. This offers some protection to borrowers, but it could also be problematic if you need to borrow more.

Short repayment terms: Part of the reason payday loans can get borrowers into trouble is due to their extremely short repayment terms. The repayment period on a payday loan is typically two weeks.

Likely won’t help your credit: In many cases, payday lenders don’t report on-time payments and loan payoffs to credit bureaus. That means these products don’t help borrowers build credit. But if someone misses payments or fails to repay the loan, the lenders will often report the delinquent account, further dragging down the borrower’s credit score and making it that much harder to obtain better financing products in the future.

Aggressive collection practices: Borrowers have reported that lenders have threatened to have them arrested or have contacted their employers to force them to repay their debts — actions that could further jeopardize their financial stability. In extreme cases, payday lenders can garnish your wages to collect what you owe. They need a court order to initiate the garnishment process, but some will threaten to do so even without legal backing in an effort to intimidate delinquent borrowers into paying.

Alternatives to payday loans

When you’re in a financial emergency, it’s easy to panic and jump at the first offer of cash you see. But you may have more options than you realize, even if your credit score is low and you have little to no savings. Payday lending carries substantial risks, so it’s worth considering the alternatives.

Apply for a secured loan

Painful though it is to put, say, your engagement ring or a treasured heirloom on the line, you may need to opt for a secured loan if you have bad credit and don’t have a cosigner. You may also want to meet with lenders and show proof that you’re reliable via bill statements or records of other loans you’ve been paying on time.

It’s likely that you’ll incur a high-interest rate, but not higher than you’d find with a payday loan. Repaying the loan on time will help your credit score as well. The lender will report your timely payments to credit bureaus, and your borrowing ability and options will gradually improve.

Take out a payday alternative loan

Some credit unions offer payday alternative loans: they function similarly to payday loans, in that they are short-term and provide quick access to cash for borrowers with bad credit. However, the interest rates are much lower than with payday loans — McClary estimated that they are usually between 18% to 21%, though they can be higher than this in some cases. Credit unions will sometimes bundle these loans with other services and incentives to help people escape the payday loan debt cycle altogether.

Todd Christensen, an Idaho-based financial counselor, and coordinator of the Money Fit Free Financial Wellness Program, gave the following example. If a borrower wants to take out a $500 loan, the credit union might offer them $1,000. Rather than give them the full cash amount, however, the lender will hold half of that in a savings account. Once the borrower pays off the loan, whether that’s in six months or a year, they’ll have a $500 savings fund that could make the difference between needing a payday loan and being able to cope with financial emergencies in the future.

“The payday loan alternative might put somebody in a better position to improve their financial stability rather than just giving them a means to an end with a quick loan approval,” McClary added.

Apply for a zero- or low-interest credit card

If you have good credit but are having cash flow issues, consider applying for a credit card with a zero percent or low-interest rate. Companies sometimes offer credit cards with promotional introductory periods, during which you’ll pay no or little interest on purchases for a period of several months to a year, depending on the lender’s terms.

You may also get a good introductory rate on balance transfers and use the card for cash advances as well. A zero percent interest credit card can also be used to consolidate high-interest debt, giving you more manageable monthly payments for a set period of time.

Ask your employer for an advance on your paycheck

Some companies will issue paycheck advances to employees, so talk to your boss before looking at payday loans. You’ll get the money you need to cover your expenses without incurring the astronomical interest rate you would with a payday lender.

Look for opportunities to generate additional income

Depending on your line of work, you may be able to pick up overtime hours or take on a few more responsibilities at your job to earn more money, McClary said. You might also consider taking on a part-time job or joining the gig economy by offering freelance services on the web or in your community to make extra cash. Hiring yourself out to do odd jobs or help people with errands, dog-walking, and babysitting can be quick ways to make money and build up a steady stream of side work.

Ask family or friends for a loan

No one likes asking relatives for money, but you’re all but guaranteed to get a better interest rate by taking a loan from loved ones. You also won’t have to worry about a credit check or waiting several days or weeks before receiving the money.

To reassure your family members or friends that you plan to repay them, explain the situation and why it’s not going to become a regular occurrence. Then work together to decide on a reasonable repayment schedule and interest rate, and put the agreement in writing. Having that to refer back to will be helpful if you run into problems making payments on time or they decide they want to call the loan in sooner than you had agreed.

Sell other assets

Consider whether there are assets you can sell quickly for extra cash. A family boat, furniture you rarely use, designer handbags, and even clothing may be used to help cover your emergency expenses.

However, Christensen cautioned that it’s unwise to sell big-ticket items that you still need. They may earn some cash in the short-term, but you’ll end up having to replace them soon after, so you won’t really be ahead.

Talk to a debt counselor

A debt counselor will help you identify ways to consolidate your debt so you can pay it off faster, possibly at a lower interest rate. They’ll also review your budget with you to look for areas where you can save or make smarter spending decisions.

According to Linda Jacob, a financial counselor at Consumer Credit of Des Moines, people don’t have to give up things like their coffees or other routine purchases when getting their finances in order, but there are other ways to get what you want and need. As an example, she suggested buying items like snacks and drinks in bulk at Costco, instead of purchasing them as one-off items every day. Simple, strategic changes can help you funnel more money into your emergency savings so that you don’t have to take out payday loans.

If you’re already in debt on payday loans, a debt counselor may be able to work out an arrangement with the lender on your behalf. Some lenders will agree to a repayment plan that allows you to make manageable monthly installments and have a clear timeline for getting out of debt.

How to take out a payday loan safely

If you’ve exhausted all other options and decide a payday loan is the only choice left to you, do so carefully. Consider following these steps:

Research lenders carefully: Don’t take out a loan from the first lender you see. Compare the terms of several different lenders to minimize fees you’ll pay. Payday loan companies are legally required to disclose all rates and fees under the Truth in Lending Act. You should also vet the lenders through established channels such as the Better Business Bureau and state attorney general’s office. You want to know that they haven’t been involved in nasty legal battles or reported for abusive or illegal behavior.

Verify that a lender is officially registered with the state as well. Christensen said he’s seen a surprising number of cases in which the payday lender from whom a client has borrowed wasn’t registered with the state, making their operation illegal. And even if a borrower finds out their lender is operating illegally, they may not be able to get out of the obligation easily, particularly if they’ve given the company access to their bank accounts.

Jacob noted that some payday lenders operate in Native American tribal territories where they can take advantage of tribal immunity laws that put their lending practices outside the jurisdiction of U.S. laws. This allows them free reign to charge whatever interest rates they choose, so you should be particularly meticulous about researching these lenders’ rates and practices. You need to know whether a company is legal and reputable before you engage in a financial contract with them.

Make sure you understand your loan terms: Once you set up a loan agreement, make sure you’re clear on the repayment terms. Pew Charitable Trusts reported that some companies would automatically withdraw only interest and fee payments on the agreed-upon payment dates. This meant the borrower wasn’t making progress on paying down the principle, therefore extending the life of the loan.

Only borrow exactly what you need: McClary advised that borrowers ensure that the payday loan they borrow is enough to cover their emergency expense before they decide to take on that additional debt. If you can only get a loan for a portion of what you need, you’re exacerbating the problem rather than solving it.

“You might want to take a step back and think about some other ways you can resolve the issue before you go and borrow from a company that’s going to charge you the highest possible fees and only gives you a fraction of what you need,” McClary said.

Bottom line

Covering income gaps or emergency expenses can be incredibly stressful. But taking the time to evaluate all of your choices and look for ways to meet your needs without going into debt will pay off tremendously in the long run.

Payday loans are particularly risky for borrowers, so make sure you know what you’re taking on — and how you’ll manage that debt — before making that decision.

 

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