Payday Loans vs. Personal Loans: An Overview

If you need to borrow money, you have some options. For example, you can consider an easy-to-obtain payday loan for small amounts of money if you believe you can repay what you’ll owe with your next paycheck. On the other hand, you might prefer a personal loan despite the application process because it will provide you with more funds, cost you less, and involve a longer repayment term.

Payday loans and personal loans have the same essential characteristics common to all loan types. Money is borrowed for a period of time, at a specific interest rate, and must be paid back by a specific date. Furthermore, the money borrowed can be used for a variety of reasons, although the payday lender doesn’t need to know the loan’s purpose, while the personal lender will probably ask.

However, these loans vary significantly in ways that can have a big impact on the borrower: the approval process, the cost of the loan, the length of the repayment period, the risk of added debt, and more.

Read on to learn which loan may fit your borrowing needs best.

How Payday Loans Work

Payday loans are short-term unsecured loans that are very easy to obtain. With their ease of access comes predatory fees and interest; they are currently illegal or restricted in more than 25% of U.S. states.

Easy to Obtain

Payday loans involve relatively small amounts of money. Moreover, lenders might request some proof of income, but they won’t require collateral to secure your loan. Broadly, they make no specific determination of whether or not a borrower can repay a loan.

Normally, they’ll simply request that you provide them with access to your financial account electronically so that they can withdraw the money you owe on the date that it must be repaid. Or, they may request a handwritten personal check for the amount owed, which they’ll deposit on the due date.

Short Repayment Term

Payday loans are intended to be paid off quickly. Typically, this means in a couple of weeks or by the time a borrower receives their next paycheck or pension check.

Borrowers can get into greater debt and financial trouble by failing to meet the repayment due date. If that occurs, lenders will tack on high late payment fees that make it that much harder to pay off the amount owed.

Expensive to Borrow

Those who make payday loans usually charge exorbitantly high interest rates. This rate can average 400% and be as much as 780%.

Because of these rates and the fees that lenders charge, payday loans are considered predatory by some.

Fourteen states and the District of Columbia prohibit payday loans:

• Arizona
• Arkansas
• Colorado
• Connecticut
• District of Columbia
• Georgia
• Maryland
• Massachusetts
• New Jersey
• New Mexico
• New York
• North Carolina
• Pennsylvania
• Vermont
• West Virginia

In five states, payday loans are legal but have some restrictions:

• Kentucky
• Mississippi
• Montana
• New Hampshire
• South Dakota

In all other states, payday lending is legal.

Each state that allows payday loans applies its own laws to lenders to restrict interest rates and fees and thus protect consumers.

According to the Consumer Financial Protection Bureau (CFPB), the majority of payday loans aren’t paid off on time.

How Personal Loans Work

Personal loans are installment loans. They can be secured or unsecured, but they always have longer terms and lower interest rates than payday loans. Unlike with a payday loan, lenders do evaluate your credit history to discern whether you will be able to pay back a personal loan.

Complete an Application

A personal loan involves a visit to a financial institution that makes personal loans, followed by a loan application. You can also visit a lender online, if you prefer.

Whether or not the lender gives you a loan depends on your application and whether you accept the terms of the loan. These terms will include the amount loaned, the interest rate to be charged, the repayment dates and overall term, late fees, etc.

If your loan is approved, the lender will provide you the funds via a direct deposit to your bank account or by check. After the loan is funded, you can use the money as you see fit.

Secured or Unsecured Loans

Personal loans may be either secured or unsecured. For instance, a lender may require that you provide collateral for any loan they make. If you fail to repay the loan, the lender will then keep this collateral. The collateral could be some form of financial asset, such as securities or a certificate of deposit (CD). Or it could be a physical asset, such as a car.

Some lenders may offer unsecured loans, but these may come with higher interest rates due to the lack of collateral.

Requirements

Lenders normally require a particular credit score, a certain level of income, and a specific debt-to-income (DTI) ratio for the personal loans that consumers seek.

How Do People Use Personal Loans?

venuscurves.commissioned a national survey of 962 U.S. adults from Aug. 14, 2023, to Sept. 15, 2023, who had taken out a personal loan, to learn how they used their loan proceeds and how they might use future personal loans. Debt consolidation was the most common reason why people borrowed money, followed by home improvement and other large expenditures.

Key Differences

There are several notable differences between payday loans and personal loans:

• Use: People usually seek payday loans of around $500 for unexpected financial needs and plan to repay them within a couple of weeks. Personal loans are usually sought to finance a major purchase, to consolidate debt, or perhaps to make needed repairs. They have much longer repayment periods.
• Cost: Payday loans have much higher interest rates than personal loans and may overwhelm borrowers with hidden fees and charges.
• Accessibility: Payday loans can be easier to obtain than personal loans because there are few requirements for them. With some payday lenders, you can even get a loan without a bank account, as long as you have a prepaid card account.
• Credit score impact: Most payday lenders don’t report your loan to credit bureaus, and paying it off doesn’t help you build or improve your credit. On the other hand, personal loans will appear on your credit report, and on-time personal loan payments can help you to improve your credit score.
  

The Bottom Line

Payday loans are almost always more expensive than personal loans. They can be riskier as well, since added fees can increase the debt to a level that’s difficult to pay off quickly. A personal loan will usually be the better borrowing option, even for small loan amounts. And if you can’t get a personal loan, it might be wiser to try to borrow from family members or with your credit card before seeking a payday loan (unless you’re absolutely sure you’ll be able to repay on time).