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One of the reasons that I dislike payday loans so very much is because of the terribly high interest rates that the payday loan companies get away with charging. Couple that with the high fees, and it doesn’t take a genius to see why most people who know anything about personal finance will agree with the “parasitic lending” tag that I throw at them. By comparison, a personal loan isn’t much better. Or is it?
Personal loans have some of the same high interest rates, after all. Aren’t they just another way for the dastardly financial institutions to charge high rates, and rake in the high profits? Well, yes and no. Yes, they do charge high interest rates for personal loans, but there’s a very valid reason for that. And, as a generality, the rates are not as high as those charged for the payday loans. So, why do institutions charge higher rates for personal loans? The answer is in the guarantee.
Guarantee? What the heck am I talking about? In a typical consumer loan, you’re buying something. Instead of a personal loan, you get an auto loan, a mortgage, or a recreational vehicle loan. In exchange for the loan money, the lender gets a claim on the title of the thing being bought. If you default on the loan, the lender can repossess the car, house, or ATV that you bought with the money. Because they have that collateral, the risk of losing money on the loan is decreased, and they can afford to give you a lower rate because of that decrease.
A personal loan, has no such collateral. The only guarantee that you will pay the loan back is your signature. Coincidentally, that’s why they will sometimes be called “signature loans”. Because the lender cannot repossess your signature, the risk of default is raised. And, because it is raised, they charge higher interest rates.
At this point, you’re probably asking yourself, “What’s the difference between a personal loan and a payday loan, then?” Truthfully, there is very little different. The one difference, and it’s one that makes a big difference, is that a personal loan is usually issued by a financial institution like a bank or credit union, whereas a payday loan is issued by that shady pawn shop across the street. And, as a general rule, banks and credit unions are a bit more upstanding than the pawn shop. In most cases, they have a good reason to treat you fairly. They want your business. Not just your next loan, but your savings too. If they treat you poorly and charge outrageous rates, you’re likely to find somewhere else to put your money. That pawn shop could care less.
Another difference, that bears mentioning, is that banks and credit unions will usually require that you have a good to excellent credit rating before giving you a personal loan. For obvious reasons. The risk is already higher without collateral, so they don’t want to risk their money lending it to people who have sub-average credit scores. The pawn shop could care less.
Have you ever borrowed a personal loan from a bank or credit union? From the pawn shop?
photo credit: nerdcoregirl
I started this blog to share what I know and what I was learning about personal finance. Along the way I’ve met and found many blogging friends. Please feel free to connect with me on the Beating Broke accounts: Twitter and Facebook.
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John | Married (with Debt) says
I’ve never had a payday loan or a personal loan. Maybe the closest I’ve came is using a balance transfer check or something like that, something that was not secured by collateral.
Hopefully I can keep enough of a buffer to prevent me needing cash that quick, but life can be cruel sometimes and you never know.
I’ve taken one personal loan out. I used it to consolidate some credit card debt at the beginning of my financial journey towards beating broke. The rate was high, but was still lower than the rates on the credit cards, so it was a good move for me. I’ve also seen some loans that are combo loans where the loan is partially secured. Sometimes that can get you a better rate.
I have had a line of credit for over 25 years. It is tied to the prime rate of interest. I use it for short term borrowing to take advantage of opportunities. Right now it has a zero balance.
Miss T @ Prairie Eco-Thrifter says
We are like Krant. We have a LOC and use it for opportunities. We never carry a balance.
Elise @ Black Freelancer says
I have borrowed for a personal loan from our credit union(s) on two separate occasions. I don’t feel that a personal loan from a credit union (or reputable) bank is the same as a payday loan. I’ve had both.
The payday loan fees are…exorbitant (if that’s a strong enough word). They are impossible to deal with when trying to re-negotiate the payoff of the loan. Some of them do offer an opportunity for you to pay the loaned funds back monthly (instead of all at once when you are paid), but the interest charges and associated fees almost make it not worth it.
On my loan with the credit union, there are very few fees, and the interest rate is fair (based on our credit profile). I already have a loan amortization schedule and many times the bank is willing to reconsider alternative payment options if you aren’t able to pay (depending on the size and “friendliness” of the bank).
Van Beek @ Stock Trend Investing says
Thanks for explaining all this. I always thought that a payday loan was an advance that you got from your employer on your salary. No, I have never taken any personal loan and I’ll try to keep my ignorance.
I took a personal loan once just because the bank offered it – such a stupid move but its been paid off for years.
Personal loans can be a necessity for some people but it’s not a good idea to get into the habit of using a personal loan to help organise your finance situation.
Quite true, I have always thought that I would never need a payday loan and that only losers apply for them… but I had to once and it was a real emergency. They are super expensive but it helped me then.
Hugo Shelley says
I don’t really think personal loans are scams, but like scams, it will lead you to more financial traps if mishandled. But as a precaution, it is also advisable to do a research on the loan companies where you would like to get a loan. If possible, get feedbacks from previous lenders as well.