Emergency expenses can be stressful, especially if you live paycheck to paycheck. When financial disaster strikes and your rainy day fund has run dry, it might be necessary to borrow money.
While you have several options for borrowing money, two popular choices for a short-term loan are a payday loan and a personal loan. Let’s take a closer look at how these loans work and which might be a better choice for your personal finance situation.
What is a payday loan and how does it work?
A payday loan is a short-term loan due for repayment in two to four weeks, usually for a small loan amount such as $500 or less. Payday loans are also referred to as cash advances because they are intended to offer access to emergency money ahead of your next payday.
Payday loans are relatively easy to obtain. The approval process involves verifying you’re over the age of 18 with a valid form of identification, proof of employment, and an open bank account.
In exchange for this flexibility, most payday lenders charge enormous fees and high interest rates. According to the Consumer Financial Protection Bureau, a typical payday loan carries an annual percentage rate (APR) of almost 400% percent.
In order to pay off the payday loan, payday companies usually require borrowers to write a post-dated check for the full balance of the loan, including fees, or to provide authorization to electronically withdraw funds from their bank or credit union. If the loan hasn’t been repaid by the due date, most payday lenders cash the check or withdraw the funds.
In some states, payday lenders can roll over or renew a loan, charging fees to extend the due date past the next pay period. The CFPB says rollovers trap consumers in a cycle of debt and laws aimed at curbing the predatory practice have been largely ineffective.
You can see a complete list of the current state laws regarding payday lending here.
What is a personal loan and how does it work?
In contrast to payday loans, a personal loan is a traditional loan that can be taken out from a credit union, traditional bank, or online lender. Most personal loans are unsecured loans, which means they don’t require collateral.
Some personal loan lenders may steer you into a secured personal loan, where the borrower offers assets such as a home, vehicle, or even insurance policy as collateral to guarantee loan repayment. Collateral might be required for loan approval if you have a low credit score or a high debt-to-income ratio, but the loan usually comes with lower interest rates.
Personal loans are sometimes called installment loans because the loan terms provide a lump sum upfront, anywhere from $1,000 to $50,000, which borrowers repay in monthly payments over a longer period, usually two to five years.
When you start the application process, the lender will run a credit check with the major credit bureaus and ask you for detailed financial information such as bank statements, pay stubs, and in some cases, income tax returns. While approval for personal loans usually takes longer than payday loans, some online lenders offer same-day approval.
Because of how personal loans work, many borrowers use personal loans to consolidate debt, make home improvements, or pay for larger purchases like a boat or a big event such as a wedding. According to Wells Fargo, interest rates for personal loans range from 8.49% to 24.49% APR, depending on your credit history and loan terms.
Payday loan vs. personal loan: Key differences
Need cash fast? It might be tempting to head to the nearest payday loan provider, but you should carefully consider whether a personal loan might be a better fit for your financial needs.
Let’s say you decide to borrow $500 from a payday lender and end up having to roll the debt until you can pay it back about four months later. Depending on the state, a 2022 study from Pew Charitable Trusts says you’ll have to pay as much as $1000 in interest and fees – in addition to the loan amount.
If you were to take out a new loan for $1,000 through your bank or credit union, even at a high-interest rate of around 11.95% APR, you’d pay $129 in interest and have two years to repay the loan.
In summary, payday loans tend to be extremely high-interest loans that provide quick cash for those with a checkered credit history that might prohibit them from securing a personal loan. Personal loans offer an average interest rate with a much longer repayment term, but it’s harder to qualify. Some personal loan lenders also charge an origination fee and the approval process can take longer. Still, personal loans are viable solutions to consider in an emergency situation.
Read more: How to get a personal loan fast in an emergency
Pros and cons of payday loans
If you’re considering a payday loan, a snapshot of both the advantages and disadvantages may help you decide if this type of high-cost loan is worth it.
Pros of payday loans
Fast approval
No credit check
Used for any purpose
Cons of payday loans
Because of the high interest rates, payday loans generally are only a good choice when you don’t have other options. InCharge Debt Solutions, a nonprofit organization offering confidential and professional credit counseling, warns that even a cash advance on your credit card incurs more reasonable interest charges than taking up payday loan companies on their offer.
Another important thing to note is that according to the CFPB, payday loans aren’t reported to the major credit bureaus unless they go to debt collection, so paying it off won’t improve your credit score.
Read more: How to get a personal loan with bad credit
Pros and cons of personal loans
Need a lump sum for a big expense? Here are a few benefits and several drawbacks to taking out a personal loan in contrast to payday loans.
Pros of personal loans
Cons of personal loans
Like auto loans or mortgages, personal loans charge lower interest rates and have longer terms than other financing options. In return, you’ll have to convince the lender through your credit score that you’re not a default risk. Depending on how long it takes the lender to review your application, approval may take several days.
Read more: How to get approved for a personal loan: Everything you need to know about requirements
6 alternatives to payday loans and personal loans
If you’re considering either a payday loan or a personal loan as a way to keep your bank account afloat during hard times, remember there are other options for borrowing money.
1. Get an advance on your next paycheck
Sometimes, it’s as simple as contacting a manager or human resources and asking how you can go about getting an advance on your next paycheck. It’s common practice for many employers to extend this as a courtesy to their employees.
2. Get a cash advance from your credit card
If you don’t think you’ll get lender approval for a personal loan but you have a credit card, consider using a cash advance offer. These offers have relatively high interest rates – but they’re better than payday loans and might provide a grace period before the rate hike kicks in.
3. Increase your income
While this isn’t realistic in emergencies, temporarily increasing your cash flow by taking on a side hustle or selling stuff around the house you’ve been meaning to get rid of might be a way to avoid borrowing money.
4. Talk to a credit counselor or a financial adviser
If you have a poor credit score or find yourself frequently in a feast or famine debt cycle, there are nonprofit agencies and organizations that offer free credit counseling. You can find resources at the National Foundation for Credit Counseling and credit.org.
5. Find a Payday Alternative Loan (PAL) at local credit unions
Credit unions sometimes offer Payday Alternative Loans (PALs), which are meant to provide loans under $2,000 with a max APR of 28%. You can check out mycreditunion.gov for more information about this program, administered by the National Credit Union Administration (NCUA).
6. Borrow money from family or friends
And last but not least, if you find yourself in a tough spot, family or friends may be able to help. You can also contact community and local charities that may be able to help with unmet needs such as food, housing, and utilities.
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