Microloans and payday loans are sometimes conflated, but very different types of financial products. Both are small loans to low-income individuals who typically have no credit score or access to traditional financial products. However, microloans are designed to help low income individuals start businesses, whereas payday loans are designed to give short term credit between paychecks.
In this post, we’ll dive into the key differences between microloans and payday loans.
What is a microloan?
Here’s how Gobankingrates.com defines microloans:
“Microloans are small, short-term, low-rate loans specifically targeting startups in need of capital. Some microloans are offered by nonprofit organizations with a specific social mission. For example, one type of microlender might seek out companies working on alternative energy, whereas another might offer startup business loans to companies run by women.”
In the developing world, the term microloan is used synonymously with microcredit, which is a small loan designed to help spur economic development in impoverished areas.
What is a payday loan?
According to the Consumer Financial Protection bureau, a payday loan is a “short-term, high cost loan, generally for $500 or less, that is typically due on your next payday.”
Payday loans tend to share a number of characteristics, including the following:
- Extremely High Interest Rates
- Short Loan Term (usually payment is due on a borrower’s next paycheck)
- Small Loan Amount
- No Credit History Required
Payday loans are not something offered by typical banks or financial services companies. Rather they are offered by payday lenders who have developed a reputation for predatory behavior. Borrowers often don’t understand the terms of the loan, and get into a debt trap where the only possible way to repay the loan is to take out another loan.
Differences Between Microloans and Payday Loans
Microloan interest rates in the United States typically fall between 7 and 20% annually, which is typically higher than long term small business loans.
Payday loan annual percentage rates, on the other hand, range from 300% to 700% according to CNBC.
Neither microloans nor payday loans are typically underwritten by traditional lenders.
Microloans are typically offered by non-profits (Kiva), government agencies (SBA), or specialized microfinance institutions (Grameen Bank).
Payday loans are offered by payday lenders. These lenders are either online or operate payday loan stores. Payday loan stores are often subject to state-level regulation. New York and Wisconsin, for example, have very different laws.
In the United States, borrowers typically need to meet certain criteria to qualify for a microloan. Small business owners must complete an application process that at a minimum, will require a credit check, bank account verification, and potentially analysis of the business. In the developing world, where it is more difficult to assess creditworthiness, providers of microlending often require completion of financial literacy coursework.
Payday lending is designed for people with bad credit or no credit. Often a payday lender will require auto draft access to a checking account and verification of income. Repayment terms are quite harsh if payment is late.