When you’re in need of emergency funding, you might not have the time or the credit score needed to qualify for traditional financing. Banks can take far too long to respond to financial emergencies and may not be willing to work with consumers with lower credit scores. Alternative financial products, like payday loans and short-term installment loans, tend to be more nimble and more open to consumers with less-than-perfect credit. Each product has its pros and cons, and one might be better for your financial situation that the other.
The Consumer Financial Protection Bureau (CFPB) describes payday loans as follows:
"Payday loans are typically described as a way to bridge a cash flow shortage between paychecks or other income. Also known as “cash advances” or “check loans,” they are usually expensive, small-dollar loans, of generally $500 or less. They can offer quick and easy accessibility, especially for consumers who may not qualify for other credit."
Payday loans can be acquired either online or through a retail location. Because payday loans don’t typically require collateral or high credit scores, interest rates are quite high. Repayment is usually due in one lump sum by the borrower’s next pay day, hence the name. Payment is made through an automatic bank withdrawal or with a post-dated check.
Easy – Payday loans don’t require collateral or a high credit score. The basic requirement is usually a steady source of income, making payday loans accessible to most consumers.
Fast – Funding for payday loans is very fast. Some companies can deliver funding within minutes of completing an application.
Convenient – Payday loans are convenient because they can be obtained online or through retail locations and don’t require collateral or credit checks.
Expensive – Because payday loans don’t require collateral or a credit check, the interest rates are very high. This financial product should only be used for short-term, emergency funding.
Availability – Payday loans are illegal in some states.
Debt Cycle – Because the entire balance of a payday loan is due within a short amount of time, the CFPB reported that "more than 80 percent of payday loans are rolled over or renewed within two weeks." This is commonly referred to as the “debt cycle.” A borrower misses their due date and their balance is “rolled over” into a new loan, along with new fees and additional interest.
A short-term installment loan involves a set number of scheduled payments with a fixed interest rate repaid over a matter of months, typically without the use of collateral to secure the loan. Amounts can range from several hundred to thousands of dollars. Short-term installment loans that cater to consumers with poor or no credit will have higher interest rates.
Longer Terms – A short-term installment loan provides a longer term than a payday loan, giving the borrower more time to repay their loan.
Predictable payments – Because short-term installment loans have fixed interest rates, borrowers know exactly how much their payments will be and when they’ll be due.
Fast – Borrowers can have funds deposited in their bank account in as little as 24 hours after their short-term loan application has been processed and approved.
Easy – While each lender has their own procedures, online applications can usually be completed in a matter of minutes.
High-Interest – Interest rates on short-term installment loans that accept low credit scores and don’t require collateral can be quite high, although they’re typically lower than payday rates. Either product should only be used when traditional financing is not an option due to time or credit restraints. To reduce the overall cost of a short-term loan, verify your lender does not charge any early pay-off penalties or fees, and pay your balance off as soon as possible.
Fees for late/missed payments – Know what fees your lender charges, including fees for late or missed payments. Set up automatic payments or use calendar reminders to avoid unnecessary fees.
Before you decide which loan product is the best fit for your financial situation, ask yourself the following questions.
How Much Time Do I Need?
Consider the amount you’ll be borrowing and how much time you’ll need to pay it back. Unless you’re certain you can repay the amount by your next pay day, the payday loan option is probably too risky. Keep in mind the CFPB statistic quoted previously that only 20% of payday loans avoid being rolled over within two weeks.
What’s Your Credit Score?
If your credit score is good enough to get approved for a short-term installment loan, you’ll benefit from the lower interest rate your score should provide. Additionally, if you pay your loan off either on time or early, it can help improve your credit score. However, if you don’t get approved for a short-term loan and a payday loan is your only option, be sure to avoid the debt cycle by paying the balance off on time.
How Much Money Do You Need?
Whether you’re looking for a payday loan or a short-term installment loan, only borrow the minimum needed to cover your emergency expense. A payday loan is usually for smaller amounts, usually maxing out around $500, whereas a short-term loan can be for thousands of dollars. Again, even if you just need a small amount, only use the payday option if you’re certain you can repay it by your next pay day.