Payday loans vs. personal loans

Payday lending is illegal and unavailable to consumers in some states. Payday loans usually have very high interest rates and carry risk. As with any loan, consumers should have a clear understanding of the fees, terms and conditions of any payday loan before borrowing.

Many people turn to payday loans or more traditional personal loans from banks, credit unions or online lenders when they’re in need of cash. Before applying for loan options, it’s essential to understand the differences between these two types of loans.

• Payday loans are typically easier to obtain, but they have higher annual percentage rates (APRs) and shorter term lengths.
• Traditional personal loans typically require a credit score of at least 640, but they often are available for larger amounts, have lower APRs and can be paid back over longer terms.

How do payday loans work?

A payday loan is technically a type of personal loan, but there are many differences between payday loan lenders and lenders offering traditional personal loans. Payday loans are typically for small amounts and have short loan terms — they are intended to be paid back with your next paycheck.

These loans are very easy to obtain and typically do not require any collateral or credit checks, though you may need to prove your income with recent pay stubs or other documentation.

Be sure to research a lender’s reputation if you’re applying for a payday loan. Some states have bans on certain types of payday lenders because of the high APRs they charge. The key is to use these loans only when they are the best option for your immediate situation. Here are some factors to consider:

1. Rates and fees

Payday loans have some of the highest annual percentage rates (APRs) in all of lending. Because these loans have very short terms – sometimes only a few weeks – lenders charge a significant fee to borrowers.

In some situations, the APR for these loans can reach as high as 780%, though the average for all lenders is around 400%. Most people don’t pay that much simply because they pay off the loan in less than a year, though.

Be sure to ask about possible fees before taking out a payday loan. If you don’t repay the loan within the short term agreed upon, there may be a sizable fee charged on top of the interest to extend the loan terms longer.

2. Loan terms

Loan terms with payday loans are very short. Typically, a payday loan is structured around the borrower’s next paycheck and requires repayment within two to four weeks. This may be a good thing for those that do not want to carry long-term debt.

In situations where you may not be able to repay the debt in full in that short time, however, this can become a cycle leading to high fees and costs.

3. Loan amounts

Payday loan lenders typically let borrowers obtain smaller loans, often a percentage of their next paychecks. This means your maximum loan amount depends on what you’ve been earning over the last few weeks.

4. Credit requirements and credit building

Payday loan lenders typically do not perform credit checks. Instead, most focus on a borrower’s employment and income to make an approval decision. Most of the time, they also do not report to credit bureaus. That means they don’t offer any real benefit to your credit-building goals.

How do personal loans work?

Traditional personal loans are typically unsecured loans provided by banks, credit unions or online lenders. You can use the money from these loans for virtually any goal you have, from catching up on existing debt to funding emergency expenses.

Personal loans require a formal application process that may be done in person or online. The lender uses your information (typically your credit information, employment history and income) to determine if they will lend to you.

The loan’s interest rate varies based on your creditworthiness. If approved, the loan is processed and directly sent to your bank account. This is often done within a few days (or longer) of receiving approval.

Typically, traditional personal loans have longer terms than payday loans, meaning there’s more time to repay your debt. They also have much lower interest rates. However, credit requirements may leave some people unable to secure these loans.

1. Rates and fees

Personal loan interest rates are related to each borrower's creditworthiness. For example, a borrower with a good credit score should receive a low APR.

However, some personal loan lenders may offer lower rates than other lenders. Also, some loans may have an origination fee or an application fee, but not all do.

2. Loan terms

Loan terms for traditional personal loans range widely. It’s possible to secure short-term loans, including ones that are due within a matter of months. More commonly, personal loans are stretched out over a period of several years and have fixed, monthly payments.

Your monthly payment may be lower if your repayment term is longer, which may make it easier to repay the loan, but you’ll pay more in interest with a longer repayment term.

3. Loan amounts

Lenders provide a good deal of flexibility on loan amounts for personal loans. It’s possible to secure a smaller loan of around $1,000, but banks and larger financial institutions may offer qualified borrowers loans for as much as $100,000, depending on the person’s income and credit history.

4. Credit requirements and credit building

Personal loans are typically credit-building tools. Most banks, credit unions and online lenders report activity to the credit bureaus each month, which may help you to build a strong credit history.

Most lenders base approval decisions on your credit history and score, however. That means you may need to have a good credit score to obtain a loan in the first place. Some online lenders may offer more flexible terms.

Payday loans vs. personal loans at a glance

Payday loans and traditional personal loans have many differences. The most significant is typically the APR charged on the loan, but term lengths, available loan amounts and credit requirements also vary significantly between the two types of loans.

Other payday loan alternatives

Payday loans offer the benefit of not requiring a credit check, which may help individuals who have lower credit scores obtain the funds they need. However, payday loans are often problematic and costly. If you can’t get a traditional personal loan and don’t want a payday loan, there are payday loan alternatives that can also help you get some cash.

Payday loan alternatives include:

• Working more hours. One option is to work more hours at your current position to earn extra money to meet your needs.
• Getting a short-term side job. It may be possible to temporarily pick up a side job, such as a work-from-home gig, to help you to add a bit more money to your budget.
• Selling items. This could be done through online marketplaces or at a garage sale. Selling items you don’t need anymore helps you declutter your home while making money.
• Negotiating with creditors to lower monthly payments. This may help to make repayment of existing debt a bit easier.
• Talking to local credit unions. These lenders may have options for loans that are less expensive and easier to obtain.
• Borrowing a payday alternative loan (PAL). Some credit unions offer short-term PALs that could help you get up to $2,000.

Bottom line

It’s common to need to borrow money. You may need cash to repair your car, consolidate debts or keep your finances together after a rough few weeks. The good news is that you have a number of options for getting the money you need, including payday loans and personal loans.

Payday loans and personal loans both have their place in providing opportunities for individuals to get the money they need. A payday loan is generally easier to obtain, and it can be a good way to secure necessities.

However, it can also lead to a debt cycle where you're borrowing money to pay off an existing rate that’s higher each time. Consider alternatives, like a traditional personal loan, that may help you restructure your debt and meet your other financial needs.