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People tend to think of all debt as being created equal. If you owe a $300 payment at the end of the month, what’s it matter how that money was borrowed?
But the type of debt you incur can affect every part of the repayment process. Depending on factors like interest rate and loan term, borrowers can have vastly different experiences repaying the same amount of money.
So how do two popular debt products, payday loans, and personal loans, stack up? Here’s what you need to know.
How a Payday Loan Works
A payday loan is a short-term loan, also known as a check loan or cash advance. Most payday loans have a small maximum amount, around $500 or less, and carry huge fees. According to the Consumer Financial Protection Bureau (CFPB), most payday loans have a 400% APR.
Payday loan recipients agree to repay the total amount borrowed within a short period of time, along with any interest and fees. Most payday loans are due within 30 days – often before the borrower is scheduled to receive their next paycheck. A payday loan is unsecured, and therefore has no collateral or assets backing it.
Payday loans are designed for those with poor credit and limited access to traditional debt products like personal loans and credit cards. It’s also relatively easy to qualify for a payday loan. All you need is to be 18 years or older and have a valid form of ID, a bank account and proof of employment.
The payday loan cycle
In theory, a borrower takes out a payday loan when they’re a little short on cash, repaying it when their next paycheck comes in. In reality, most borrowers struggle to come up with the amount borrowed before the due date. They are then forced to roll over the loan, interest, and fees into a new loan with a new set of fees.
This creates a cycle of debt that is incredibly difficult to escape from. The CFPB reports that 80% of payday loans are renewed multiple times, with the majority of borrowers paying more in fees and interest than they originally borrowed.
If a borrower fails to renew a loan before it comes due, the lender will attempt to take the money out of the borrower’s bank account. If the bank account doesn’t have sufficient funds, the account holder will be charged overdraft fees until they can deposit more money. This is another example of why payday loans can be so costly.
Here’s another surprising fact about payday loans – they usually don’t report activity to the three major credit bureaus, Experian, Equifax, and TransUnion. This means that even if borrowers make the payments on time, they won’t see an increase in their credit score.
How a Personal Loan Works
A personal loan can be taken out from a bank, credit union or online lender. Most personal loans are unsecured and not backed by any collateral. Personal loans that do have collateral behind them typically have lower interest rates than unsecured personal loans.
A 2018 U.S. News survey found that consumers most often took out personal loans for debt consolidation, home improvements, unexpected medical costs, car repairs, large purchases, vacations, and weddings or other celebrations.
You can also take out a personal loan for fertility treatment, pet medical expenses, cosmetic surgery, and more. Some lenders have specific limitations on what the borrower can use the money for, while others are more lax.
If you have good credit, you can qualify for a personal loan with a lower interest rate than your credit card. That’s why the most popular reason to take out a personal loan is to pay off credit card debt. Borrowers can save hundreds in interest with this strategy.
Those lower rates are also why some people use a personal loan to pay for major expenses instead of a credit card. Unless you have enough money saved to pay in cash, big ticket items like cars, furniture and medical bills can be cheaper with a personal loan.
Personal loan terms are often between two to seven years. The amount you can borrow is usually between $1,000 and $50,000, with interest rates for personal loans ranging between 4% to 36%.
Interest rates on personal loans vary depending on the person’s credit score, debt-to-income ratio, and other factors. Approval may also depend on the amount you’re applying for and the reason for the loan.
Conquer your student debt. Refinance now.
How Payday and Personal Loans Compare
The main difference between a payday loan and a personal loan is the basic terms. A payday loan is an extremely short-term loan usually due within a month, while the term for a personal loan is at least two years.
Personal loans have a much lower interest rate than payday loans, which can be helpful if you’re using it as a debt consolidation loan or to pay for an emergency. Payday loans also have a small maximum amount, usually $500 or less. Some personal loan companies allow you to borrow as much as $100,000.
Payday loans are much easier to access than a personal loan. You just need to stop into a payday loan store, where you can have the loan within 30 minutes. A personal loan can take a few days to process.
One lesser known distinction between payday loans and personal loans is that only personal loans show up on your credit report. If you take out a personal loan and make payments on time, your credit score will climb. That will help you qualify for better loans and interest rates in the future.
A key similarity between payday and personal loans is that both are often unsecured, so there’s no property or asset behind the loan. In other words, if you default on a payday loan or personal loan, there’s nothing the lender can seize.
If you have the option between a payday loan and a personal loan, the latter will always be the less expensive option. If you try to apply for a personal loan and don’t qualify, look at what else you can do.
Can you sign up for a side hustle or ask your boss for overtime? Can you put some expenses on a credit card? Can you borrow money from your family or friends? All of these alternatives will be better – and less costly – than taking out a payday loan.