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Business News/ Money / Personal loans vs payday loans: What is the difference between the two? MintGenie explains

Personal loans vs payday loans: What is the difference between the two? MintGenie explains

Payday loans can be risky for several reasons, and it’s crucial to understand these risks before contemplating one.

Distinguishing between personal loan and payday loan. (Mint)Premium
Distinguishing between personal loan and payday loan. (Mint)

Facing a difficult financial situation can certainly challenge your commitment to saving, but there are smarter approaches than depleting your emergency fund or selling investments. An alternative option is to explore loans from banks or other financial institutions such as NBFCs. However, the decision between opting for a personal loan or a payday loan depends on various factors and should be made after carefully considering your ability to repay the loan within the given timeframe.

In nearly every scenario, a personal loan is a preferable choice over a payday loan. Here’s why:

  • Cost: Personal loans typically offer much lower interest rates compared to payday loans. While a personal loan might have an APR ranging from 6% to 36%, payday loans can have APRs exceeding 400%, leading to a cycle of debt.
  • Repayment terms: Personal loans provide more flexible and manageable repayment terms. You usually have months or even years to repay the loan, whereas payday loans are due by your next payday, placing significant pressure on your budget.
  • Debt trap: Payday loans can easily lead to a cycle of debt. Due to the short repayment term, you may only be able to afford to pay the interest rather than the principal loan amount. This situation can compel you to take out another loan to cover the initial one, resulting in a cycle of high-interest debt.

Here are some alternatives to consider before turning to a payday loan:

  • Negotiate with creditors: If you’re falling behind on bills, try negotiating a payment plan with your creditors. They may be willing to collaborate with you to prevent late fees.
  • Sell unwanted items: Think about selling unused or unnecessary items to generate some quick cash.
  • Borrow from family or friends: If feasible, consider borrowing money from a friend or family member, ensuring a clear repayment plan and agreed-upon interest rate.

Payday loans should be considered a last resort due to their high costs and the risk of trapping you in a cycle of debt. If you’re contemplating a payday loan, a personal loan is a far better alternative, provided you meet the qualifications.

Frequently Asked Questions (FAQs)

Q. Are payday loans risky?

Payday loans can be risky for several reasons, and it’s crucial to understand these risks before contemplating one. Here’s an overview of the main dangers:

- Exorbitant interest rates

- Brief repayment period

- Cycle of debt

Q. What are the common misunderstandings about how personal loans affect your credit score?

There are certainly some prevalent misunderstandings about how personal loans affect your credit score. Here are two of the most common ones:

  • 1: Obtaining a personal loan always damages your credit score.
  • 2: Personal loans are a fast solution for boosting your credit score.

Q. What factors should you consider when taking out a personal loan to improve your credit score?

Key factors to consider when obtaining a personal loan to enhance your credit score include:

- Temporary decrease: Applying for a personal loan results in a hard inquiry on your credit report, which can lead to a minor, short-term drop in your score (typically a few points).

- Long-term advantage: The positive effect stems from consistently making on-time payments. This showcases responsible credit management and can substantially boost your score over time.

- Loan amount: Only borrow an amount that you can genuinely afford to repay punctually. Missed payments or defaults can significantly damage your credit score.

- Interest rate: Compare different lenders to secure the lowest possible interest rate. A lower interest rate means more of your payment goes towards reducing the principal, enabling you to pay off the loan more quickly and improve your credit utilisation ratio.

- Repayment term: Opt for a loan term that allows you to make monthly payments without difficulty. While extending the term may appear easier on your monthly budget, it can result in more interest accumulating over time.

- Secured loan: If you own a valuable asset such as a car, you may consider a secured loan, which typically offers lower interest rates. However, be mindful of the risk of losing the asset if you’re unable to repay the loan.

Q. What is the minimum CIBIL score required to qualify for a personal loan?

There isn’t a universal minimum CIBIL score requirement for personal loans in India. Here’s why:

- Lender discretion: Ultimately, lenders establish their criteria for loan approval. This encompasses minimum credit score requirements, which can differ based on the lender’s risk assessment.

- General benchmark: That said, a CIBIL score of 750 or higher is typically viewed favourably by most lenders when considering personal loan applications. This score suggests a strong credit history and enhances your likelihood of approval with advantageous terms, such as lower interest rates.

- Lower scores possible: It’s still feasible to obtain a personal loan with a CIBIL score below 750. However, the interest rates may be considerably higher to compensate for the elevated risk to the lender.

Q. Why is it important to aim for a better credit score when applying for a loan?

If you have the opportunity, prioritise improving your credit score before seeking a personal loan. This may include making timely payments on current debts, reducing your credit utilisation ratio, and correcting any inaccuracies on your credit report.





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Published: 13 Apr 2024, 07:09 PM IST
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