A payday loan is not an installment or revolving loan. It is a short-term loan you repay in one lump sum on the due date. Keep reading to learn about the ways each type of loan works.
Revolving Credit
You are probably familiar with revolving credit from your unsecured or secured credit card. A home equity line of credit (HELOCs) is also a revolving line of credit. Revolving credit starts with a credit limit (or credit line), the amount of credit you can use to charge purchases, take cash advances, and pay bills. You can use any amount of your credit line at any time, up to the limit.
Revolving loans only charge interest on your credit balance – the amount of credit you are actually using. You must repay the credit you use, but the repayment terms are flexible. The credit line usually requires only a minimum monthly payment, such as 5% of your outstanding balance. You can carry a balance from month to month and repay it on your own schedule as long as you pay the minimum due each month.
For example, you have a credit card with a $5,000 limit, and you spend $1,000 on purchases and bills. The card has a monthly billing cycle and produces an account statement on the cycle’s last day showing the $1,000 balance. Nearly all credit cards have a grace period of 21 to 28 days (from the statement date to the payment due date) in which you can avoid interest charges by paying the balance in full.
Suppose you pay an amount between the minimum and the full balance. In that case, your unpaid amount will carry into the next billing cycle, and you’ll incur daily interest on the current balance until fully repaid.
From our example, if you pay the minimum amount of $50 on the due date, your unpaid balance will be $950, and your available credit will be ($5,000 – $950), or $4,050. Because you carry an outstanding balance beyond the due date, grace periods will suspend until you repay the unpaid amount.
As you can see, the balance and available credit will yo-yo up and down as you charge new purchases and make further payments. You’ll pay the daily interest rate (i.e., the annual percentage rate or APR divided by 365) on each day’s balance until fully repaid, at which time the card will reinstate grace periods.
Revolving Credit Advantages
- Flexible borrowing: You borrow the amount you need when you need it (up to the credit limit);
- Flexible repayment: You can repay on your own schedule as long as you make the monthly minimum payments;
- Reasonable interest rates: Typically ranging from 8% to 36% APR;
- Avoiding interest: You can avoid revolving credit card interest by paying the entire balance by the payment due date.
Revolving Credit Disadvantages
- Possibly high total costs: If you make only minimum payments each month, the total amount of interest you’ll pay will skyrocket;
- Credit score impact: Your interest rate depends on your credit history and score.
Installment Loans
An installment loan is a lump sum you repay in monthly (usually equal) installments, at a fixed or variable interest rate. The term reflects the number of installments required to repay the loan. Each payment consists of interest and principal portions.
Familiar installment loan examples include personal loans, payday alternative loans from credit unions, mortgages, vehicle loans, and student loans. Some installment loans are secured by collateral, such as your home or car, while others are unsecured (e.g., personal and student loans). Installment loan terms can range between 2 months (for payday alternative loans) and 30 years (for mortgages).
You must pay the installment amount due each month to avoid late charges. You can pay more than the installment due each month to pay off the loan sooner than expected. But first, ensure that the extra payment amount goes toward reducing the loan principal, not to prepay interest charges.
Some loans carry a prepayment penalty – a fee the lender charges when you pay off the loan early. The monthly payment amount depends on the loan size, interest rate, and loan term. When you borrow money, you want a loan term that results in affordable monthly payments.
Suppose you take a $5,000 personal loan at a 10% interest. If you agree on a one-year term, you’ll make 12 payments of $440 each, including $274.95 in interest. You might instead ask for a five-year term with 60 payments of $106 each. The loan interest will be $1,374.11.
Notice how extending the loan term decreases the monthly payment size but increases the total cost. Your credit score helps determine the interest rate you’ll pay for the loan.
Installment loans often have origination fees, generally 1% to 5% of the loan amount. You must either prepay the fee upfront or roll it into the loan principal, in which case you’ll pay interest on the fee.
Installment Loan Advantages
- Affordable payments: By getting a longer loan term, you’ll reduce the size of each payment;
- Larger loans: Depending on the loan type, you may be able to borrow larger amounts than those available from credit cards or payday loans;
- Lower interest rates: Typically no higher than 36% and usually much lower, these loans are cheaper than payday loans.
Installment Loan Disadvantages
- Fees: You may have to pay origination and prepayment fees;
- Possibly high overall cost: The longer the term, the more interest you’ll pay;
- Credit score impact: Your interest rate depends on your credit score and payment history.
Payday Loans
Payday loans are small, high-interest, short term cash loans repayable on your next payday. You repay this type of loan in one lump sum on the due date. The APRs are high, but the short loan duration limits the total cost of payday loans.
For example, the APR on a 14-day payday loan averages 391%. The lender expresses the interest as a finance charge tacked onto the loan principal. If you borrow $500 for 14 days at an APR of 391% (equal to a $75 finance charge), you’ll repay $575 on the due date.
If you fail to repay on time, the payday lender will roll the finance charges and penalties into a new loan due on your next pay date. You can see how a few rollovers can significantly expand your debt, so it’s essential to repay a payday loan on time.
Payday Loan Advantages
- Easy access: A bad credit score doesn’t impact your interest rate. All you need is a reliable income source, such as employment or government benefits;
- Fast funding: You may be able to collect the loan proceeds by the next business day.
Payday Loan Disadvantages
- High interest rates: Rates are higher than those for credit cards and installment loans;
- Risk: You can get into a payday loan trap if you fail to repay the loan;
- No credit building: Payday loans neither help nor hurt your credit score.
The bottom line is that there are different loans for different needs. Choose a loan based on its availability and your ability to repay, and avoid borrowing more than you can afford.
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