In 1968, Congress passed the Federal Truth in Lending Act. The new law was a game changer for the credit industry. One of the major concepts it introduced was the annual percentage rate or APR. At the time, lenders used a variety of methods for calculating interest. Some lenders disclosed the monthly interest rate. Others used misleading “add-on” or “discount” interest rates while yet others would give a low-ball interest rate and then add huge fees and charges. These techniques would often understate the simple interest rate of the loan and confuse borrowers.
Now lenders are required to disclose the total cost of loans by providing potential borrowers with an APR. Has this regulation improved things?
Payday Lenders and APRs
Many payday lenders, trade associations, and even some regulators feel that requiring all lenders to disclose the APR of loans is unfair because it makes payday loans look more expensive than they are. After all, they claim, payday loans only have terms of 14 to 30 days, so it’s unfair for lenders and unhelpful for borrowers to convert a fixed-fee for a short-term loan into an annualized percentage rate.
An example often used to support this view is the taxi and airplane illustration. You take a taxis for short trips and airplanes for long trips, right? The cost per mile of a taxi is much higher than the plane’s cost per mile. For instance, let’s assume a 500-mile return flight costs $500, which would represent a $2 per mile rate. A one-mile taxi ride in Los Angeles will cost you the $10 minimum charge: a $10 per mile rate.
That doesn’t mean cab drivers are overcharging their passengers. It’s just a different type of service. To require the taxi driver and the airline to report the cost of their service as a rate per mile would overstate the actual cost of the taxi ride and ignore the fact taxis are only used for short trips and emergencies.
Similarly, or so the argument goes, payday loans are not meant to last more than 14 or 30 days; so it’s misleading and unfair to require payday lenders to report an annualized rate.
Why Calculating The APR Of A Loan Is Useful?
Nice try payday loan lobbyists. The only problem with that argument is that taxi drivers do provide customers with a mile rate, and people still ride cabs. Similarly, mortgage loans don’t quote their interest rate over 30 or 15 years, and auto loans don’t give a 5-year interest rate. They both use the annual rate, and customers are smart enough to understand the difference in rate is explained by the length of the term, the size of the loan and the risk taken on by the lender.
You also never hear credit card companies complaining they have to disclose the annual percentage rate equivalent. Despite the fact credit card users have the option of paying their balance in full every month – something nearly half of all cardholders do — without paying any interest.
Having a standardized rate all lenders use, such as the APR, is a useful tool because it provides consumers with a benchmark rate to compare the different types of credit available to them. To illustrate, if you qualify for both a credit card that offers a 20% APR and a payday loan with a $15 fee for every $100, you may wonder which is the best deal. However, if you compare their APRs: 20% and 391%, it becomes clear that credit cards are a much cheaper form of credit. That is useful information for borrowers, not so much for payday lenders.
However, APR doesn’t always make payday loans look bad. In fact, payday lenders should embrace them as a marketing method to highlight the benefits of payday loans over more expensive credit options. For instance, compare the APR of a $100 payday loan to the late fee on a credit card, utility bill or a bounced check fee for a similar amount, and payday loans start to look like a bargain.
How Do You Calculate The APR Of A Loan?
Calculating the APR of a loan is simple. You just need to know three things: Amount borrowed, the total finance charge and the term of the loan.
Once you have that information, it’s simply a four step arithmetic exercise. To illustrate, let’s calculate the APR on a $1,000 payday loan with a $200 finance charge and a 14-day term.
Divide the finance charge ($200) by the loan amount ($1,000)
Multiply the result (0.2) by the number of days in the year (365)
Divide the total (73) by the term of the loan (14)
Multiply the result by 100 and add a percentage sign
In our example the math would look like this: $200 / $1,000 x 365 /14 x 100 = 521.42%.
Ouch! No wonder payday lenders don’t want to disclose the APR of their loans.
How Do You Calculate the APR of a Payday Loan When You Only Have a Fixed Fee for Every $100?
Although most lenders are required to disclose the APR of their loans, they often bury it in the small print. Payday lenders prefer to present the cost as a fixed fee for every $100 you borrow. How do you calculate the APR in this case?
Easy. Add these two steps to calculate the total finance charge.
Divide the total loan by 100
Multiply the result by the fixed fee for every $100.
Now you have the total finance charge. You can now calculate the APR using the method explained above.
For example, let’s say you borrow $650 and you know there is a $30 for every $100. To calculate the total finance charge, divide $650 by 100 and multiply by $30. The total finance charge in this example is $195. Now we can calculate the loan’s APR using the method above. The result is a jaw-dropping 782.14%. ($195 / $650 x 365 days /14 days x 100).
There Is a Better Alternative
The APRs used in the examples above, 521.42% and 782.14%, are typical APRs for many payday lenders. However, the payday lending business is booming. One in 20 households have used a payday loan. It is a $9 billion industry. There are more payday lenders in the United States than McDonald’s or Starbucks. The reason lenders can get away with such high interest rates is that many people, particularly those going through financial hardships, need fast money and don’t have the credit or the assets to qualify for ordinary sources of credit.
There are better alternatives available. Online lenders, such as Avant or NetCredit, provide fast loans to people with all types of credit at interest rates that are much lower than those offered by payday lenders. The rates are much higher than those offered by traditional lenders, but they consider borrowers with poor and fair credit. These lenders also report payments to credit bureaus, which can help rebuild your credit. Plus, they have no problem disclosing the APR of their loans.