What's the Difference Between Payday Loans and Installment Loans?

Melissa Horton
by Melissa Horton
Published: March 17, 2020

Several different loan types exist in the world of lending from a variety of loan providers. Although that truth is helpful for borrowers in need of financing, it can be equally confusing. Determining which loan is the best choice for your financial needs requires some knowledge of common loan types and how they work.

Payday loans and installment loans are two common types of borrowing, but they have significant differences that make them stand out from one another.

According to a recent report by the PEW, an estimated 12 million borrowers in the United States each year use payday loans to cover an unexpected or emergency expense. Consumer use data for installment loans is not widely documented, but one of the leading lenders in the market serves an estimated 800,000 customers per year. However, the popularity of installment loan vs. payday loan use should not weigh on the decision to use one over the other.

Instead, determining which loan option is a smart choice starts with understanding what payday and installment loans are and how they differ from one another.

A Quick Comparison of Payday and Installment Loans

Payday Loans Installment Loans
Loan amount $500 – $1,500 $1,000 – $10,000
Repayment terms Two weeks or next pay period Six months to five years
Credit check Not required Required
Available lenders Online, in-person branches Online, in-person branches
Interest Rates Fixed, high triple digits Fixed, low single to double-digits
Reports to credit bureaus Only if repayment is not made–does not help build credit Yes for the duration of the loan which can build credit over time
Typical borrower Age 25 – 44, lower-income household Possible higher-income household but with bad to fair credit
Loan approval Nearly anyone with a paycheck qualifies for approval May require a hard credit check and income to qualify
Prepayment penalties Potential fee with some lenders Potential fee with some lenders

What is a Payday Loan?

Payday loans are small-dollar short term loans offered online to borrowers who need immediate access to cash. Financing with a payday loan can range from $500 up to $1,500 in most cases, and repayment is due when the borrower receives their next paycheck. There is no credit check required for a payday loan, but instead, a borrower needs to provide a recent pay stub to verify they can repay the amount they borrowed.

Lenders offering payday loans may do so via online payday platforms or through physical branch locations.

The Pros and Cons of Payday Loans

Payday loans can be helpful in certain circumstances because of the advantages they provide. Although the perks of payday loans may be attractive, caveats exist. If you are thinking of getting out a payday loan keep in mind the downsides also.

Advantages of Payday Loans Disadvantages of Payday Loans
The ability to get cash quickly. Full payment is due within two weeks with most payday loans.
No need for a credit check. The fees charged are much higher than other loan options.
Short repayment term. Borrowers can quickly get in a cycle of debt if they cannot repay.
Can cover small financial emergencies or unexpected bills. Missed payments or default on a payday loan negatively impacts credit.

What is an Installment Loan?

An installment loan, on the other hand, is a longer-term loan that can be in higher amounts than a payday loan. These loan types can range from $1,000 up to $10,000 from many lenders, depending on the creditworthiness of the borrower. Because larger loan amounts are offered, installment loans require a credit check and in some cases, verification of income.

Unlike payday loans, installment loans have repayment schedules that extend several months to a few years. The monthly payments due are fixed, creating a predictable repayment plan.

Installment loan lenders may be available through online platforms similar to payday loans as well as traditional banks and credit unions.

The Pros and Cons of Installment Loans

Getting an installment loan comes with a handful of advantages, that can be outweighed by the disadvantages, however.

Advantages of Installment Loans Disadvantages of Installment Loans
The ability to access higher loan amounts. A credit check is required, so not every borrower qualifies.
Lower interest rates than payday loans. The ability to borrow more can lead to a higher monthly payment.
Longer repayment period which can mean a lower monthly payment. Repayment extends for several months to years which may be a significant commitment.
Fixed interest and loan amount. Missing a payment or defaulting on a loan hurts credit.

How Does Each Work?

Payday loans and installment loans work in different ways. The most significant differences include credit requirements, repayment options, interest rates, and fees.

Credit requirements – payday loan lenders do not run a credit check to approve your loan, but they do need to see proof of income, often from a recent pay stub. Installment loan lenders do run a credit check to determine if you are eligible for a loan. Bad credit matters less for a payday loan than it does an installment loan.

Repayment options – payday loans are due to be repaid within two weeks. If payment cannot be made, you may be able to roll over the loan to the next pay period, for a significant fee. Installment loans are repaid over several months to years. This schedule is set from the start of the loan and does not change.

Interest rates – the interest rates charged on payday loans are often in the triple digits, some as high as 400%. Installment loans, however, typically have interest rates between 5 and 35%, based on your credit score when applying.

Fees – payday loans may charge fees in addition to the interest rate, including late payment charges, extended repayment charges, and returned payment fees. Installment loans may charge an origination fee at the time a loan is approved, as well as late payment and returned payment fees. These fees vary from lender to lender.

Risks Involved with Payday Loans and Installment Loans

One of the most substantial risks with payday loans is the cycle of debt a borrower may face. If you are unable to pay off the money you borrowed by your next pay period, many payday lenders allow you to roll over the debt into a new short-term loan. The payment is then extended for two weeks. Although this sounds appealing on the surface, it comes at a steep cost.

Payday loans that are rolled over incur a fee which is added to the total amount due. This means a larger payment is owed when the next pay period arrives. Many borrowers are not provided this information upfront, and they struggle to pay on time and in full. Above the financial burden of a higher loan amount, non-payment of a payday loan lowers your credit score. This can will make it more challenging to get an affordable loan in the future.

Installment loans have fewer risks than payday loans, but issues still exist. Borrowers may be inclined to borrow more than they need given the higher loan amounts available. Overborrowing can lead to a monthly payment that is difficult to manage. Similar to payday loans, missing a payment on an installment loan can be detrimental to your credit score.

Lenders offering installment loans may also be less than transparent with the fee structure. For instance, the interest rate offered may not include other fees associated with the loan, such as:

  • Origination fee
  • Application fee
  • Prepayment penalties
  • Funding charges

These typical installment loan costs add to the total amount you pay for borrowing money, but they are not always included in the stated interest rate. You should take a close look at the annual percentage rate (APR) charged on your loan, as this is a better indicator of the interest rate plus additional fees.

Although the APR for either an installment loan or a payday loan may be listed on the loan agreement or term sheet, it’s helpful to know the typical APR ranges for payday and installment loans.

For payday loans, the APR can add up to 400 percent, given the high-interest rate and short repayment period.

Installment loans, on the other hand, may have an APR between 6 and 36 percent, although this could be higher for bad credit loans. The better your credit, the lower your APR for an installment loan.

When Should I use One or the Other?

Determining the type of loan that works best for you can be a daunting task, but think about the following scenarios where one option may make more sense than the other.

Payday Loan Scenarios

You can consider a payday loan if you:

  • Have a short-term, immediate borrowing need for a financial emergency.
  • Know the loan can be paid in full with the next paycheck.
  • Need a loan need for less than $1,000.
  • Aren’t concerned about rolling over the loan into the next pay cycle.

Installment Loan Scenarios

An installment loan is likely a better option if you:

  • Have a longer-term need for a loan for a significant purchase or considerable expense.
  • Can budget for a fixed monthly payment for several months or years.
  • Have a higher loan amount needed.
  • Can qualify for a loan based on credit history and credit score.

Summary

Overall, payday loans should not be a go-to source of financing given the high costs borrowers pay to access funds. The potential horror scenario – cycle of debt, that comes with payday loans is a significant drawback as well that can impact your financial health negatively.

However, as a last resort, payday loans (including payday loans from direct lenders) may be beneficial for covering short-term, urgent financial needs. For most borrowers, installment loans are often a better choice compared to payday loans in terms of fees charged, repayment options, and loan amounts.

References and Sources
  1. “How Installment Loans Work” – https://www.investopedia.com/articles/personal-finance/072316/how-installment-loans-work.asp

  2. “What are the costs and fees for a payday loan?” – https://www.consumerfinance.gov/ask-cfpb/what-are-the-costs-and-fees-for-a-payday-loan-en-1589/

  3. “Payday loan alternative may be a better deal, but has its own risks” – https://www.bankrate.com/loans/personal-loans/payday-loan-versus-installment

Melissa is a financial literacy professional who is passionate about educating individuals and business owners about the power of smart money management.

She has used her undergraduate degree in finance and her MBA in marketing to establish a comprehensive financial planning firm serving clients in Washington, DC and the surrounding area.

During her 13 years in the financial services industry, Melissa has taught thousands of clients how to create and sustain financial freedom through better understanding what their money has the potential to do for them. In addition to working with clients, Melissa contributes financial literacy and money management articles for several publications across the web.

You may also like

Michael Lefler
by Michael Lefler
Published: May 19, 2020
Melissa Horton
by Melissa Horton
Published: February 24, 2020
Kerry Vetter
by Kerry Vetter
Published: January 9, 2020
Kerry Vetter
by Kerry Vetter
Published: February 21, 2020
Kerry Vetter
by Kerry Vetter
Published: June 12, 2019