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Payday loans vs. installment loans

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Payday loans are designed for people with bad credit or little credit history. These loans come with sky-high interest rates and payday lenders can be predatory. Taking out high interest loans to cover everyday expenses often launches borrowers into a cycle of deeper debt. Despite this, IBISWorld, an industry research firm, predicts that the payday loan industry will grow 5.1% this year.

In order to curtail the dangers of the payday lending industry, some states have imposed strict rate caps and restrictions on payday loans. The Payday, Vehicle Title, and Certain High-Cost Installment Loans rule from the Consumer Financial Protection Bureau also provides some protection against this type of predatory lending.

For those looking for an alternative to a payday loan, installment loans have become a popular option. However, these loans come with their own set of risks.

Payday loans vs. installment loans

Payday loans and installment loans are similar in that they both offer a short-term solution when you need cash immediately. The main differences between payday loans and installment loans are whether they’re secured (meaning if collateral is needed to secure the loan), the amount you can borrow, and how long you’re given to repay the loan, plus interest and fees.

Payday loans are typically a smaller amount, like a few hundred dollars, while installment loans can reach amounts up to $10,000. Payday loans are also repaid in one lump sum by the borrower’s next paycheck period. Conversely, installment payments are paid off in increments over multiple months or years.

Although payday loans and installment loans offer a fast source of funding in a pinch, they often lead to further financial turmoil for already struggling borrowers due to steep interest rates and high fees.

Payday and short-term loans

Payday and short-term loans are usually unsecured and don’t require collateral. They typically are offered in amounts of $500 or less at interest rates of 400% APR or more, depending on your state’s regulations.

These loans must be repaid by the borrower’s next payroll period in full. Some states allow lenders to renew the loan if borrowers need more time.

Other types of short-term loans include:

  • Car title loans. Car title loans use your car’s title or “pink slip” as collateral for a short-term loan. Typically, you’re given 30 days to repay the loan in full; otherwise, the lender will take possession of your vehicle.
  • Pawn shop loans. These loans require using a valuable asset as collateral in exchange for a small portion of its resale value. If you fail to repay the loan, the pawnbroker keeps your asset.

Problems with short-term loans

If payday loans are supplying cash to nearly 12 million Americans in need and make credit available to an estimated 11 percent of Americans who have no credit history, how can they be bad? The answer is complicated.

Payday loans allow lenders direct access to checking accounts. When payments are due, the lender automatically withdraws the payment from the borrower’s account. However, should an account balance be too low to cover the withdrawal, consumers will face an overdraft fee from their bank and an additional fee from the payday lender.

Obtaining a payday loan is easy — which is why many of them fall into the predatory lending territory. Borrowers only need to present ID, employment verification and checking account information. Payday lenders don’t review credit scores, which means they’re too often granted to individuals who cannot afford to repay them.

People who are constantly strapped for cash can fall into a cycle of payday loans. When original loans are rolled over into new, larger loans under the same fee schedule, borrowers fall into trouble, because of high interest and fees.

Installment loans

Installment loans are part of a non-bank consumer credit market, meaning they are originated from a consumer finance company instead of a bank. These loans are typically offered to consumers with low incomes and credit scores who can’t qualify for credit through traditional banks.

Installment loans range from $100 to $10,000. The loans are repaid monthly within four to 60 months. These loans can be secured or unsecured.

These are similar to payday loans in that they’re intended to be of short-term use and are targeted to low-income individuals or those with low credit scores. However, the two loan types differ greatly in their lending methods.

Pew Charitable Trusts, an independent non-profit organization, analyzed 296 installment loan contracts from 14 of the largest installment lenders. Pew found that these loans may be a less costly, safer alternative to payday loans:

  • Monthly payments on installment loans are more affordable and manageable. According to Pew, installment loan payments take up 5 percent or less of a borrower’s monthly income. This is a positive, considering payday loans often sucked up significant portions of paychecks.
  • It’s less expensive to borrow through an installment loan than a payday loan. The Consumer Financial Protection Bureau found that the median fee on a typical 14-day loan was $15 per $100 borrowed. Installment loans, however, are much less expensive, according to Pew.
  • These loans can be mutually beneficial for the borrower and lender. According to Pew’s report, borrowers can pay off debt in a “manageable period and at a reasonable cost,” without compromising profit for the lender.

Risks of installment loans 

At first look, installment loans are more cost-effective and seem to be a safer route for consumers. However, they come with their own risks:

  • State laws allow two harmful practices in the installment lending market: selling of unnecessary products and charging fees. Often, installment loans are sold with additional products, such as credit insurance. Credit insurance protects the lender should the borrower be unable to make payments. However, Pew claims that credit insurance offers “minimal consumer benefit” and can increase the total cost of a loan by more than a third.
  • The “all-in” APR is typically higher than the stated APR listed in the loan contract. The “all-in” APR is the actual percentage rate a consumer pays after all interest and fees are calculated. Pew lists the average all-in APR for loans of less than $1,500 to be as much as 90 percent. According to Pew, the non-all-in APR is the only one required by the Truth in Lending Act to be listed, causing confusion for consumers who end up paying much more than they originally thought they were going to.
  • Installment loans are also commonly refinanced, and consumers are then again charged nonrefundable origination or acquisition fees. Additionally, nonrefundable origination fees are paid every time a consumer refinances a loan. As a result, consumers pay more to borrow.

Other alternatives to short-term loans

If you’re in need of funds, there are other alternatives to consider aside from payday loans and installment loans. Here are some options:

  • Credit-builder loans. These loans are designed for borrowers with low or no credit. The financial institution will disburse credit-builder funds into a locked savings account which you’ll only get access to after making fulfilling all installment payments toward the loan.
  • Payday Alternative Loans. Payday Alternative Loans, or PALs, are provided by credit unions for their members. These loans are for a small amount below $1,000 which are repaid over a month or a few months, depending on the institution.
  • Ask your employer for an advance. Some employers offer paycheck advances to their employees. Remember, if you advance a portion of your next paycheck, that means your next pay period will be at a reduced amount.
  • Negotiate a payment plan with creditors. Contact your creditors, whether for hospital bills or a credit card bill, to explain your financial situation. They might be able to share payment plan options you weren’t aware of.

Short-term loans may seem like easy solutions, but make sure you are researching to find the best option for your situation.