Payday Loans vs. Installment Loans: Which Is Better?
A $400 loan repaid at the next payday for $460 creates a budget problem in a different way than a $400 loan repaid in 4 monthly payments of $115. In the example, both loans cost $60. The first requires the full repayment of $460 with a single paycheck. The second loan requires a 4-month repayment, leaving the borrower with a monthly bill for $115.
The main difference between payday and installment loans is in the repayment schedule. With an installment loan, you can reduce the burden of each payment by increasing the number of payments. Although payday loans are short-term loans, the cost of the loan is often high. Before you decide on a loan offer, look at the cost of the loan, the cash you are receiving, and the cash you will have available on the due date.
What the loan names tell you
Payday loans are very small loans that are typically due in a single payment within 2 to 4 weeks. Installment loans, on the other hand, are repaid in a series of payments. Auto and mortgage loans are common types of installment loans. This comparison will assess other, more personal, forms of cash lending.
Overlaps may occur. Certain payday loans allow for repayment in more than one payment. Although a loan may be repaid in more than one payment, it should not be mistaken for a low-cost loan. Payday loans may be legal in your state. Make sure you know your state’s laws if payday loans are allowed.
Personal installment loans can last a long time (months or years). With these loans, payments are typically set and constant. However, the agreement may state that the interest rate can change. Loan amortization occurs when the loan balance is recovered through repeated loan payments.
Compare two offers that put $400 in your hands
The illustrations below show the effect of different repayment schedules and assume equal dollar costs. These examples are for illustrative purposes and do not represent any loan offers. The examples provided below assume you will receive $400 and that you will pay no other costs and pay on time. The first payment for the installment loan is due one month after the loan is disbursed. The loan carries a fixed rate of interest and is to be repaid in four installments.
| Offer detail | Single-payment payday loan | Personal installment loan |
|---|---|---|
| Cash you receive | $400 | $400 |
| Payment schedule | One payment of $460 after 14 days | Four monthly payments of $115 |
| Total scheduled repayment | $460 | $460 |
| Cost above the cash received | $60 | $60 |
| Approximate APR | 391% | 70% |
Annual Percentage Rates (APR) show the cost of a loan by including fees and expressing rates on an annual basis. The APR on the payday loan example is roughly 391%. The $60 charge on the payday loan is for a loan that is to be repaid in 14 days. So the APR of 391% does not mean the payday loan has to be repaid at that rate in 14 days. The APR of the installment loan is also high, but less than the payday loan, for the same reason as the payday loan; the money has to be repaid over a longer period of time. High-cost credit should be used with caution.
Total dollars or APR alone will not give the whole story. The same dollar cost can have different deadlines, as demonstrated in the table. It is essential to consider the difference between APR and interest rate when there are fees charged on the offer’s advertised rate.
Use a lender’s written disclosures to analyze loan offers. Consider the payments and fees that a lender charges separately. Count a fee only once. For example, if a fee is charged and then included in the payments, it should not be included again. If a lender charges a fee and then gives you the net amount of the loan, the funds that you receive will be less the fee. Adjust your comparison to reflect the effect of fees. For example, if you are comparing offers to pay the same expense, you should also consider the effect of the fees.
Most personal loans need to disclose the APR and finance charge and provide a schedule of payments. A finance charge discloses a loan cost. Assume a finance charge does not disclose all possible costs to the consumer. These costs may include charges for lateness and costs for the return of the payment.
Find the due date your budget cannot cover
Imagine your next paycheck is for $1,200. You have to budget $900 of that to cover your housing, food, and other expenses and payments. That means you only have $300 for this pay period. With that, you’ll have to cover the new loan and other costs you couldn’t plan for.
The $460 payday payment leaves a $160 gap. Receiving a paycheck on the due date does not close it. Paying the lender in full would mean cutting basic expenses, finding more money, or taking out a different loan.
With $300, the first payment of $115 would leave $185. However, payments will not begin for a month after the loan is disbursed, and income and expenditures for that month must be analyzed. The next three payments also must be considered in the budget. If the budget only has $90 remaining before the third payment, there is a $25 gap. Money that is remaining after a pay period is not additional, independent funds for subsequent payments.
Payment frequency makes a significant difference here. A payment of $115 every two weeks is $230 at the end of the month if there are two payment dates, and $345 if there are three payment dates. Paying $115 once a month and paying $115 every two weeks are financially Different. Make sure to check the exact dates of payment, especially for larger and final payments.
See what happens if the first plan fails
Let’s say the payday loan allows you to extend the due date once for another $60, if the state allows it. You extend the due date on day 14 by paying $60. On day 28, you still owe $460. Total outlay is now $520 ($400 borrowed + $120 in charges). The first $60 payment did not reduce the principal (the amount borrowed).
Payment of a rollover fee usually does not decrease the debt. The CFPB states that rollover fees do not reduce the principal balance. Restrictions on rollovers may apply. If you are not sure that you will be able to repay the next due amount, find out if an extended repayment plan is available. Make sure that you get and keep a written copy of the plan, as well as the fees charged under the plan.
Something to consider with an installment offer is if a smaller payment is spread over more months. Let’s say eight monthly payments of $65 result in a total of $520. That costs $120 more than the same $400 received, compared with $60 for four payments of $115. The smaller payment buys more time at a higher dollar cost in this example. A longer term does not always cost more, so compare the actual totals.
Terms that can change the choice
A repayment schedule does not resolve all issues. If a loan requires a vehicle or other property as collateral, missed payments can put that property at risk. Bank-account withdrawal authorization is a different situation. It allows the lender to automatically withdraw the payment. If the account does not have sufficient funds, there can be bank and lender charges. Repayment authorizations can be given if you understand how repayment occurs.
The process and terminology surrounding credit checks and credit reporting may differ. Ask if your application will involve a hard credit check. Find out if your lender will report your payments. Payday loans may negatively impact your credit, and other debt sent to collections may be reported as well.While some may assume that an installment loan will positively impact credit, that is not always the case.
When requesting a payoff amount, state the date you expect to make repayment. There may be multiple factors affecting the amount of savings, including falling balance interest, charges set at the loan origination, and prepayment penalty. The loan agreement should explain the above terms. An assumed early payoff should not be the only thing contributing to affordability.
When neither offer solves the shortfall
If a loan is structured in such a way that additional loans would be taken out by making the initial loan payment, then that loan clearly does not fit the budget. Likewise, if making the smaller payments would still create a cash-flow shortage and crowd out the payment of other, more important bills, then extending the payments would not alleviate the cash-flow shortage.
If you don’t need cash right away, you may be able to put off paying a bill by entering into a payment arrangement. For an expense that can’t wait, payday loan alternatives include options with varying costs and eligibility requirements. Compare any available arrangement with the loan offers using the same cash amount and due-date test. If both loan schedules fit, weigh their dollar costs and APRs against the extra time each gives you to repay.