Why a personal loan is far better than a payday loan

Wednesday 10 December 2014, 9:41AM
By Harold French

We’ve all been there before: a crop of unexpected expenses blow the family budget and there’s no choice but to look for a loan – and typically, the money’s needed fast. Be that as it may, being hasty is possibly the worst thing to do in this situation and can have consequences further down the line, so take some time to choose a loan provider which will not only solve your immediate cash flow crunch, but also deliver a fair deal which doesn’t leave lingering financial after effects.

The most likely scenario when you are in a jam is to consider a personal loan rather than taking out a payday loan, particularly when you consider that Westforce Credit Union reported recently that some payday lenders are charging between 500% and 700% interest per annum.

Before taking a look at the differences between a payday loan and a personal loan, let’s have a quick look at the New Zealand law which governs the provision of loans – the Credit Contracts and Consumer Finance Act. According to the Commerce Commission, there is no cap which applies to the interest rate which can be charged on an outstanding balance. What that means in practice is that a loan provider can charge any interest rate it likes. All that is required is that there must be full disclosure in the paperwork (the initial disclosure statement).

With that backdrop, let’s consider a payday loan.

These are short term, high interest loans which act as a cash advance; money can be accessed very quickly, in some cases in under an hour – but there is a catch and that is the cost of the loan. Depending on the provider, interest rates can be in the thousands of per cent per annum, with some loan providers charging interest of 1% per day on payday loans. While one per cent looks innocuous, it translates into an annual rate of 365%.

There is also an establishment fee on every loan which dramatically drives up the cost of accessing that money: a $15 charge on a $100 loan over 14 days represents a return to the lender of 391%. Great for them, really, really not so for you.

Thanks to these outrageously high interest rates (remember, the Official Cash Rate is 3.5% and home loans cost as little as 5.75% per annum), there is no shortage of payday loan providers – and many of them are companies which you may never have previously heard of.

The advantages of a payday loan is that there is typically very little paperwork involved; employment history may be required and proof of receiving paycheques, but often little more is needed and processes tend to be quite loose, differing from one organisation to another, or even from one branch of the same organisation to another. In other words, the people providing payday loans are really keen to get your business, because they make massive profits off your need to get money quickly.

While low or no paperwork may seem worthwhile when you need money fast, it isn’t an advantage at all. Reputable financial services providers conduct rigorous checks to make sure that you are in a position to repay your loan as they don’t want to repossess your vehicle or other goods; loan processes are in place as much to protect you as they are there to protect the company business.

The alternative is a personal loan.

Aside from a massively lower interest rate, probably the biggest difference between a personal loan and a payday loan is the term: where payday loans are taken out over a period of days, weeks or at most, one month, the personal loan tends to have a minimum period of 6 months. The other differences are that personal loans tend to be for larger sums of money which is repaid over a longer period of time (for example, a GE Money personal loan has a minimum of $3000 with a minimum repayment period of 6 months).

And what is the difference in interest rate? A good interest rate is what you can afford. The GE Money personal loan interest rate calculator is a good tool for working that out. In short, use a reputable company with proven lending processes (which include a thorough assessment of your ability to repay any loan). This results in a far more palatable total loan cost. The good news, too, is that these processes tend to be very well refined, so they don’t take a long time and you can still access money quickly – and once you have established a history with a lender, the next time a loan is needed, it is even easier.

With personal loans, the security you are able to offer directly influences the interest payable – so, if you have fixed property (a house) and proof of employment, you are likely to access the better rate.

Typically, an establishment fee is also charged on a personal loan; however, because it is spread over a longer time period, it doesn’t represent an out of proportion return for the loan company.

If there is a simple rule (and there is) it is this: avoid payday loans even if you are in a pinch; they will cost you far more and it’s money you can’t afford to lose. Rather choose a personal loan instead.