The Differences Between a Payday and 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 fast access to cash, but they work very differently in terms of how you repay the borrowed amount. Here's a look at the key distinctions and some guidance on which type of loan may be preferable depending on your circumstances.

What is a payday loan?

A payday loan is a short-term, high-cost loan that typically needs to be repaid in full by your next payday, usually within two to four weeks. The maximum loan amounts are relatively small, usually $500 or less.

To get a payday loan, you provide the lender with a post-dated check for the full loan amount plus fees and interest. On your next payday, the lender cashes that check to recover what you owe. If you can't repay, you may be able to roll the loan over by paying only the fees and interest, but this will result in additional high charges being added.

Payday loans have extremely high annual percentage rates (APRs) that can exceed 400%. The combination of short repayment periods and exorbitant interest rates makes these loans very difficult to pay off, which is why many borrowers end up trapped in cycles of debt.

What is an installment loan?

Installment loans, as their name suggests, allow you to repay what you borrowed in a series of scheduled payments or installments over a period of months or years. Typical repayment terms range anywhere from a few months to a few decades.

The funds from an installment loan can often be used for a variety of purposes like debt consolidation, major purchases, home improvements, and more. You'll usually repay the loan on a fixed monthly schedule, making equal payments that go toward both principal and interest.

Installment loans can be secured by collateral like a home or car title, or they can be unsecured. Interest rates tend to be lower than payday loans, but will vary based on factors like your credit score, income, and whether the loan is secured or not.

Which should you choose?

In almost every situation, an installment loan is the better choice compared to a high-risk payday loan. Installment loans:

• Are far less expensive overall due to lower fees and interest rates

• Give you longer to repay in reasonably affordable installments

• Are available in higher amounts suitable for bigger expenses

• Are less likely to trap you in never-ending cycles of debt

The only instance when a payday loan could potentially make sense is if you need a very small amount of money to cover an emergency and you're certain you can repay it quickly to avoid interest charges piling up. But in general, the high costs and short repayment terms of payday loans make them exceedingly risky.

Whenever 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 the smarter choice over predatory payday loans. For more, here are some tips for paying off loans early.

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