Payday Loans vs. Personal Loans: What’s the Difference?

A payday loan is a short-term loan intended to be repaid by your next payday. They are easy to apply for but charge high-interest rates and often have hidden fees. This makes it very easy to get stuck in a debt trap where it becomes very difficult to pay off your loan, even if you only borrowed a small amount to begin with. Conversely, a personal loan is a little more complicated to apply for but has much lower interest rates than payday loans. Because of this, personal loans are often used to consolidate debt and are a far safer way to access credit.

Here's what you need to know about the differences between these loans and how you can decide which is best for you.

Payday Loans vs. Personal Loans: An Overview

Payday loans and personal loans have some similarities. With both loans, you borrow money that must be repaid with interest at some future date. Both loans can be used to cover emergencies and to meet the cost of unexpected bills or other financial obligations.

These loans can differ significantly. Payday loans are generally used to borrow small amounts of money until your next paycheck and are very easy to arrange. You won’t need any collateral for these loans, and they can be very expensive. Because of this, they are often considered predatory lending, since they carry extremely high-interest rates, do not consider a borrower’s ability to repay, and have hidden provisions that charge borrowers added fees.

Personal loans are a much broader category. This loan is typically offered by a bank, credit union, or online personal loan lender, and you will normally need to provide them with proof that you can eventually repay the loan. Personal loans are normally for much larger amounts of money than payday loans, but you will have much longer to repay this money. The interest rates and fees for a personal loan are much lower than for a payday loan, so the overall cost of borrowing is likely to be much lower.

How Payday Loans Work

It’s normally very easy to get a payday loan. You can walk into a payday lender’s office and walk out with a loan. You will not have to give anything to the lender in order to secure the loan, as you would at a pawnshop. Instead, the lender will normally ask you for permission to electronically take money from your bank, credit union, or prepaid card account. Sometimes, the lender may ask you to write a check for the repayment amount, which the lender will cash when the loan is due.

Payday loans can be expensive. Payday lenders charge very high levels of interest: as much as 780% in annual percentage rate (APR), with an average loan running at nearly 400%. Most states have usury laws that limit interest charges to anywhere from 5% to 36%. However, payday lenders fall under exemptions that allow for their high interest. Sixteen states—Arizona, Arkansas, Colorado, Connecticut, Georgia, Maryland, Massachusetts, New Jersey, Montana, New Hampshire, New York, North Carolina, Pennsylvania, South Dakota, Vermont, and West Virginia, as well as the District of Columbia—have outright bans on extremely high-cost payday lending. Seven states—Maine, New Mexico, Ohio, Oklahoma, Oregon, Virginia, and Washington—have imposed measures of some kind, such as term limits, fee limits, or the number of loans per borrower that provide some protection for consumers, which offer some protection for borrowers.

Payday lenders say that their high interest rates are misleading because if you repay your payday loan on time, you will not be charged high rates of interest. In some cases, that might be true, but 48% of payday loans are renewed multiple times, according to the Consumer Financial Protection Bureau (CFPB), indicating that the majority of these loans are not paid off on time.

How Personal Loans Work

To get a personal loan, you need to apply to a lender. This can be a bank, credit union, or online personal loan lender. The lender reviews your application and decides whether to approve or deny it. If approved, you’ll be given the loan terms, which you can accept or reject. If you agree to them, the next step is finalizing your loan paperwork.

When that’s done, the lender will fund the loan, which means paying you the proceeds. Depending on the lender, these may arrive through a direct deposit into your bank account or by check. After the loan is funded, you can use the money as you see fit.

Personal loans may be secured or unsecured. A secured personal loan is one that requires some form of collateral as a condition of borrowing. For instance, you may secure a personal loan with cash assets, such as a savings account or certificate of deposit (CD), or with a physical asset, such as your car or boat. If you default on the loan, the lender could keep your collateral to satisfy the debt.

Personal loans can also be found online. Numerous lenders offer personal loans through their websites. You can apply electronically, get a decision in minutes, and (in some cases) get funding in as little as 24 to 48 hours after loan approval. Using a simple online personal loan calculator can help you determine what kind of payment amount and interest rate are the best fit for your budget.

Lenders can have different requirements when it comes to what credit score, income, and debt-to-income (DTI) ratio are acceptable to be approved for a personal loan. This can help you narrow down the loans that may best fit your credit and financial profile.

Key Differences

There are several key differences between payday loans and personal loans when it comes to meeting emergency expenses:

• Cost: Payday loans generally have much higher rates of interest than personal loans and may hit you with hidden fees and charges.
• Accessibility: Payday loans can be easier to arrange, especially for people with limited credit history and other financial challenges. With some payday lenders, you can even get a loan without a bank account as long as you have a prepaid card account.
• Impact on your credit score: Most payday lenders don’t report to the credit bureaus. This means 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, which will help you qualify for better loans and interest rates in the future.
  

In almost every situation, a payday loan will be more expensive than a personal loan. If you need emergency money, the best thing to do is to apply for a personal loan to see if you qualify. Then, if you don’t qualify, you can look at other options. Even then, it might be better to use your credit card, borrow money from family and friends, or try to find a part-time job.

The Bottom Line

Payday loans are almost always more expensive than personal loans when it comes to borrowing money and are riskier as well. If you are able to qualify for a personal loan, choosing this option will allow you to borrow more money, give you more time to pay it back, and charge you a lower interest rate. If you need some emergency money, you should first apply for a personal loan.