Installment loans vs. payday loans

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by Jackie Lam

Updated April 26, 2024

In a nutshell

If you're short on cash and need money in a pinch, a payday loan is a quick way to access the funds you need. However, with their exorbitantly high interest rates fees, this service is sometimes deemed predatory.

Payday loans are considered an unsecured form of debt, which means you don't have to offer the lender any collateral.
Payday loans are illegal in some states.
Installment loans have lower interest rates than payday loans. Their repayment terms are also reasonable, making them a safer financing option.

What is a payday loan?

A payday loan is marketed towards individuals with bad or no credit who need cash right away. They are often available in smaller amounts of money, and you need to pay them off in a lump sum within 30 days, or with money from your next paycheck.

In states where payday loans are offered, there is usually a cap on lending amounts, typically no more than $500. Many states also have laws that cap interest rates, loan amounts, and fees. Despite this, the APR on payday loans can be anywhere from 25% to 662% according to the Center for Responsible Lending.

What is an installment loan?

An installment loan is a type of loan, offered as a lump sum that is intended to be repaid in monthly payments over a set amount of time. Common types of installment loans are personal loans, mortgages, and auto loans. The interest rate on an installment loan is fixed, so your monthly payments are the same.

Short-term personal loans are the most similar to a payday loan. However, the interest rates and fees are much lower — the average interest rate in the U.S. for personal loans hovers at around 12.35% as of November, 2023, the latest data available from the Federal Reserve.

According to the National Consumer Law Center, three-quarters of states cap the interest rates on installment loans. The lowest cap is in North Carolina at 16% and the highest is Mississippi at 305%. The median cap is 36.5%.

Payday loans pros and cons

Let's look at the advantages and disadvantages of a payday loan:

Pros:

Quick access to cash: You can often have the money the same day.

Cons:

Expensive: Payday loans may have APRs of up to 780%.
Easy to get caught in a debt cycle: The constant borrowing — and needing to pay it back in a very short amount of time — can get you caught in a vicious debt cycle. Remember, if you borrow $500 today, that money will come out of your next paycheck. In turn, you'll have $500 less to cover your expenses in the future.
Payday lenders have access to your bank account: Some payday lenders want to pull money directly from your account for future payments. However, if you don't have that money in your bank account, you may be subject to multiple overdraft charges.
You can't change your mind: Once you sign papers on a payday loan, you can't cancel your loan.

Installment loans pros and cons

Let's look at the advantages and disadvantages of installment loans:

Pros:

Fixed interest rates and payments: You will pay the same amount each month on your installment loan.
Unsecured: Most personal loans are unsecured, which means you won't have to offer any collateral to back up the loan.
Flexible in their use: You can use proceeds from a personal loan on just about anything, including covering a financial shortfall, an emergency expense, funding a big-ticket item, or toward home renovations, among others.
Save on interest by paying off the loan early: Many personal loans don't have a prepayment penalty, so you can pay off the loan as early as possible without incurring a fee. In turn, you could pay less than anticipated in interest rates.

Cons:

Might borrow more than you need: Because you get a lump sum upfront, you might take out more money than you need.
Late payments can cause a dip in your credit score: Falling behind on your payments can hurt your credit score.
Obligated to make scheduled payments: Depending on the length of your loan, you'll be responsible for making payments each month until the loan is paid back. This could be years.

Should you get an installment loan or payday loan?

Payday loans come with staggeringly high fees and interest rates. You may be able to roll over your loan amount with the lender, but to do so continually exposes you to recurring monthly fees that can make it very difficult to break out of a debt spiral.

Installment loans come with lower interest rates and fees, and they have more flexible repayment terms. When comparing a short-term installment loan against a payday loan, it's in your best financial interest to go with an installment loan.

Payday and installment loan alternatives

If you're unsure whether a payday loan or installment loan is a good choice for you, consider these alternatives.

Credit card advances

You can take out a cash loan by visiting the partnering bank of your credit card or withdrawing cash from an ATM. While this is a convenient way to access cash, credit card advances also come with steep interest rates. The average APR for a credit card advance is 24.81%, and the fee is typically 5% of the amount of the cash advance or $10, whichever is more.

Side hustle

Instead of a payday or installment loan, you can shore up funds by moonlighting. Consider side hustles that are both lucrative and easy to get started, such as pet sitting, delivering food, or taking online surveys. The average side hustle can earn you $810 a month, which can provide the extra cash you need to tide you over until your next payday.

Home equity line of credit (HELOC)

If you're a homeowner, you can borrow against your equity stake in your home and access funds this way. While HELOCs are typically easier to get and have lower interest rates, your home acts as collateral. If you struggle to keep up with payments, you risk losing your home.

Family and friends

Family and friends may be willing to lend a hand and loan you some cash. However, you'll want to navigate this with kid gloves because it can impact your relationship. If you're considering going this route, come up with an agreement in advance so that expectations around repayment are clear.

Payday loan alternative (PAL)

A payday loan alternative (PAL) is a short-term installment loan in the amount of $200 to $1,000. The loan term is usually one to six months. You'll need to be a credit union member for at least a month, and there's usually a one-time application fee.

401(k) loan

If you need money in an emergency, you can tap into your existing 401(k) funds without incurring a penalty or taxes. You can usually borrow up to $50,000. However, you’ll be required to pay interest and pay it back within five years. The interest rates are usually lower than other types of loans, plus there's usually no credit check.

When deciding between an installment loan and a payday loan, it’s advisable to exercise caution in regards to payday loans. With their staggeringly high interest rates and fees, they're widely considered predatory and, as a result, they are banned in some states. Installment loans are a more affordable route.

Frequently asked questions (FAQs)

Are installment loans the same as payday loans?

Installment loans are different from payday loans. Installment loans have longer payment terms and lower rates: You repay the loan over time in chunks. Payday loans have shorter terms, and you typically need to pay it back in a lump sum by your next paycheck.

Do installment loans hurt your credit?

Installment loans can only help your credit, provided you keep up with your payments. However, if you consistently make on-time payments, they can help you build credit.

What is the minimum credit score for installment loans?

The minimum credit score for installment loans varies by lender, but most major lenders require a score between 600 and 700. Some lenders specialize in personal loans for fair or poor credit, however, and will loan to borrowers with scores between 300 and 580. The higher your score, the more favorable your terms and rates.

Is a payday loan better than a short-term loan?

Payday loans are known to have exorbitantly high interest rates and fees, and shorter payment terms. They're often seen as predatory. Short-term loans have far lower interest rates and fees, and are safer and less expensive.