One of the largest complaints by critics of the payday loan industry relates to the annual percentage rate that is charged on a short term payday loan which can be several hunderd percent. Annual percentage rate, sometimes referred to as “APR” is a simple measure of the effective amount of interest a borrower would pay during one full year. The APR helps to provide an apples to apples basis in deciding which vehicle has a higher or lower ultimate cost to the borrower, including other fees that may apply.
APRs are commonly used to evaluate potential mortgage loan offers as well as in evaluating potential investment products such as money market funds. Annual percentage rate is a very useful tool for loans or investments with a duration of at least one year. When you are dealing with short term loans or investments, APRs are less useful. Payday loans are high interest, short term products that typically last only two weeks.
I liken payday loans to taking a taxi home from the airport. It might cost you $40 to drive home from the airport. Now most people realize that $40 is a lot of money to pay for a ride home but people do it because it is convenient and it addresses your need. Now we all know that we could rent a car for a whole day for $40 and drive as many miles as we wish. So let’s just say we do that. We rent a car and drive 400 miles during the one day we’ve rented it. We paid $40 for 400 miles, or 10 cents per mile. The taxi ride was $40 for 20 miles, $2 per mile.
Proponents of annual percentage rates would say that in order to evaluate whether the taxi is a better deal than renting a car, we need to “annualize” to get apples to apples comparisions. So we take the price of the taxi ride ($2 per mile times 400 miles) which gives us $800. The “APR” equivalent of the rental car versus the taxi ride is $40 versus $800. Now, everyone should realize that renting a car was not the best option for us to get home from the airport regardless of how much more expensive the APR was in this case.
The same holds true for payday loans. Payday loans are two week loans, not annual loans. The high APR shouldn’t be relied upon because the loan does not last for one year. Most lenders charge $15 to $25 per $100 borrowed for two weeks. The interest rate charge being 15%-25% for the loan.
If one insists on using the APR for payday loans, the same method should be used in evaluating bounced checks, credit card late fees and utility reconnect fees. Let’s see how they stack up:
- $100 payday advance with a $15 fee = 391% APR
- $100 bounced check with $54 NSF/merchant fees = 1,409% APR
- $100 credit card balance with a $37 late fee = 965% APR
- $100 utility bill with $46 late/reconnect fees = 1,203% APR
A payday loan is an expensive choice for your credit needs. These loans should not be taken without considering all available alternatives. If you understand the nature of these loans, you will realize that they can help you in times of financial emergencies. But they are not intended to serve as intermediate or long term financing options. Please always borrow responsibly.