The Differences Between a Payday Loan and an Installment Loan (and When to Use Each)
When you’re in a financial bind and need to borrow money quickly, two common options are payday loans and installment loans. Both provide quick access to cash, but work differently in terms of repaying the amount borrowed. Here’s a look at the key differences and some advice on which type of loan might be preferable depending on your circumstances.
What is a payday loan?
A payday loan is a short-term, high-cost loan that usually needs to be repaid in full by your next payday, usually within two to four weeks. Maximum loan amounts are relatively small, typically $500 or less.
To get a payday loan, you provide the lender with a check for the full amount of the loan, plus fees and interest. On your next payday, the creditor cashes this check to pay you back what you owe. If you can’t repay the loan, you can roll over the loan by paying only the fees and interest, but this will add additional high fees.
Payday loans have extremely high annual percentage rates (APRs) that can exceed 400% . The combination of short repayment terms and exorbitant interest rates makes these loans very difficult to repay, leaving many borrowers trapped in a debt cycle.
What is an installment loan?
Installment loans, as their name suggests, allow you to pay off borrowed funds in a series of scheduled payments or installments over months or years. Typical repayment terms range from a few months to several decades.
Funds from an installment loan can often be used for a variety of purposes, such as debt consolidation, large purchases, home renovations, and more. Typically, you will repay the loan on a fixed monthly schedule, making equal payments that go toward both principal and interest payments.
Installment loans can be secured by collateral, such as a house or car, or they can be unsecured . Interest rates are generally lower than payday loans, but will vary depending on factors such as your credit score, income, and whether the loan is secured or unsecured.
Which should you choose?
In almost every situation, an installment loan is a better choice over a high-risk payday loan. Installment loans:
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Overall much cheaper due to lower fees and interest rates.
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Give you more time to repay in reasonably affordable installments
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Available in large quantities, suitable for large expenses
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Less likely to trap you in endless cycles of debt.
The only time a payday loan could potentially make sense is if you need a very small amount of money to cover an emergency and you’re confident you can pay it off quickly to avoid accumulating interest charges. But in general, the high costs and short repayment terms of payday loans make them extremely risky.
If possible, explore installment loan options from personal loan providers, credit unions, banks or online lenders. With better terms and more affordable repayment plans, they are almost always a smarter choice compared to predatory payday loans. Moreover, here are some tips for paying off loans early .