Why is the APR for Payday Loans So High?
Payday loans have a reputation of having high Annual Percentage Rates (APR). Before judging, learn what APRs are, what they mean, and how they relate to payday loans.
Interest Rate vs. Annual Percentage Rate
An interest rate describes the loan interest for a fixed period, also known as a “term.” An interest rate has two components:
- The interest rate (0.9%, 12%, etc.)
- The term (3 days, one week, two months, four years, etc.)
If you borrow $100 at 15% interest for one month, you will have to pay a total of $115 to repay the loan. The 15% interest rate describes that the cost of borrowing $100 for one month is $15.
An Annual Percentage Rate (APR) describes the interest in one year. Using the example above, if the interest rate per month is 15%, the daily interest is 0.5% (15% 30 days). The APR of the loan is 182.5% (0.5% x 365 days). For a $100 loan, the compounded interest in one year would be $182.50. The 182.5% APR indicates that the cost of borrowing the $100 is $182.50 for a year.
The Cost of Payday Loans
The high cost of payday loans is a reflection of its most basic characteristics. A payday loan is an unsecured product. It also has expensive operating costs and a high default rate.
Unsecure Financial Product
Payday loans do not have collateral, not even a guarantor. Lenders don’t have financial assets to repossess. There are no guarantors to whom they can transfer the financial obligation to. Lenders are almost powerless and vulnerable against borrowers who can default. The high interest rates balance out the risks and help cover potential losses.
Expensive Operating Costs
Payday lending is a volume-based industry. Payday lenders rely on a large volume of payday loans to make a profit. A loan has a fixed cost to maintain. The more loans, the higher the total operating cost. There are more small payday loans, resulting in higher operating costs.
High Default Rate
Research suggests that,
- Only 14% of payday loan borrowers pay on time
- A quarter of payday loans roll over at least eight (8) times
Payday lenders need incentives to lend money despite the discouraging statistics. The high interest rates keep lenders above water, away from bankruptcy.
The Confusing World of Annual Percentage Rates
The concepts of interest rates and Annual Percentage Rates may be quite a lot to take in. How much is reasonable to pay for a loan is not an easy question to answer. Loan terms, interest rate, payment frequency, loan amount, and other fees weigh in, too.
Knowledge of how each factor weighs in computing for percentage rates is powerful. It helps in grasping and comparing loans, which cut borrowing costs.
Important APR Points to Keep In Mind
1. How Long is The Term of The Loan?
Term-length indicates for how long the simple interest rate applies without extra fees. A 15% interest with a 14-day term means that as you pay in 14 days, you will only pay 15% of the loan amount as a loan fee. Extending the loan term causes more charges.
2. How is The Interest Calculated?
15% APR differs from a 15% interest fee for 14 days in that,
- The 15% APR means that 15% of the loan amount is the annual interest fee. A $100 loan will cost $15 to borrow for an entire year.
- A 15% interest rate for 14 days renews every two weeks. A $100 loan will cost $15 every two weeks.
Also, the interest can be based on either the entire loan amount or the balance payable. Paying 15% on $100 (the original loan amount) per month is one thing. The interest fee of $15 is consistent throughout the term. Diminishing interest is another thing. That is, paying 15% in interest on the remaining balance after each payment. Every month, the interest rate lowers as you pay off the loan.
3. How Often are Payments Due?
How often payments are due is determined by the number of times it rolls over. Fourteen-day loans are due every two weeks. There are 52 weeks in a year, so the loan rolls over 26 times a year.
4. Will You Receive The Entire Loan Amount?
Some personal loan lenders need 20% of the loan to be available in a savings account as collateral. You cannot touch the money until you have repaid the loan in full. In such a situation, you only have to pay off 80% in capital plus interest. You already have the money for the remaining 20% in your savings account.
5. What Other Fees are Involved?
Interest rates and APRs do not tell whole stories. There are other fees with different purposes and conditions. Additional fees to look out for are origination fees, service fees, late fees, and early pay-off penalty fees.
Payday Loans Unfairly Judged by APR
APRs look at loan interest as they grow throughout the year. It is a good tool for comparing loans – ones that lasts at least a year, that is. Payday loans rarely stretch to months, much less, years.
Payday loans charge high interest rates because it makes no sense otherwise. Ten percent APR on a $375 two-week payday loan is equal to around 0.38% in interest (10% APR 365 days). That’s $1.425 in interest for a two-week loan with no collateral, no guarantor, and easy to default.
No payday lender will survive these types of rates considering the credit access that they provide to lower-income brackets. These people live paycheck to paycheck. They do not have the luxury to save for the sake of building a good credit score. Without a good credit score, they cannot qualify for other types of loans.
Payday loan charges are reasonable when they stay true to the original terms. They turn sour when a person borrows for the wrong reasons or does not manage his/her expectations. This type of borrower can get sucked into a debt cycle that can last forever.
Payday loans offer a one-of-a-kind service that caters to the underserved. It is honest and fair that way. APRs paint it in a worst-case scenario – when borrowers fail to pay small two-week loans for at least a year.
Amanda is a senior financial copywriter at AdvanceSOS. She has more than six years of journalism experience, mostly in finance. She graduated with a Master’s degree in finance from the University of Oklahoma.