What is a payday loan? How do you calculate its annual percentage rate (APR)? Are there cheaper alternatives with lower rates? SuperMoney has the answers. Let’s start with some background.
In 1968, Congress passed the Federal Truth in Lending Act. The law introduced the concept of the APR, a game changer for the credit industry.
Before this act was passed, lenders used a variety of misleading and inconsistent methods to calculate interest. Now, all lenders must disclose the total cost of loans by providing potential borrowers with an APR.
Payday lenders and APRs: are APRs misleading?
Many payday lenders feel that requiring APR disclosure is unfair, because it makes payday loans look more expensive than they are. Payday loans only have terms of 14 to 30 days. As such, lenders say, it’s misleading to convert a fixed fee for a short-term loan into a hypothetical annualized rate.
An example that illustrates this view is the taxi and airplane analogy. A 500-mile flight on an airplane might cost $500, or $2/mile, while a one-mile taxi ride in Los Angeles will cost about $10, or $10/mile. Does this mean that taxis are overpriced? No, most would argue — it’s just a different type of service. To require both of these services to report their costs in the same way (dollars per mile) would overstate the cost of the taxi ride. Accordingly, venders argue, it’s unfair to require payday lenders to report an annualized rate.
Why APRs are useful
But there’s a problem with the taxi argument. 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. 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.
Having all lenders use standardized rates provides consumers with a benchmark rate to compare the different types of credit available to them.
For example, if you qualify for a credit card with a 20% APR and a payday loan with a $15 fee for every $100, you may wonder which is the best deal. But if you compare their APRs (20% and 391%, respectively), it becomes clear that credit cards are a much cheaper form of credit. That is useful information for borrowers, albeit not for payday lenders.
However, APRs don’t always make payday loans look bad. Compare the APR of a $100 payday loan to the late fee on a credit card or utility bill for a similar amount. The payday loan will look like a bargain.
How do you calculate the APR of a loan?
Calculating the APR of a loan is simple. You just need three numbers: the amount borrowed, the total finance charge, and the term of the loan. Once you have that information, it’s a four-step equation.
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
The result: $200 / $1,000 x 365 /14 x 100 = 521.42%.
Calculating APRs using fixed fees
Although most lenders disclose the APRs of their loans, they often bury them 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 using this information? Just add these two steps:
- Divide the total loan by 100
- Multiply the result by the fixed fee for every $100.
The result is the loan’s 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%.
Alternatives to payday loans
The APRs used in the examples above may be shockingly high, but they’re also common for payday lenders. Yet 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.
Lenders can get away with such high interest rates because their borrowers need money fast. Perhaps they’re going through a financial hardship, and perhaps don’t qualify for ordinary sources of credit.
For these borrowers, there are better alternatives. Online lenders like as Avant and NetCredit provide fast loans to people with any credit score at much lower interest rates. The interest rates are higher than most loans, but lower than payday loans.
These lenders also report payments to credit bureaus, which can help rebuild your credit. And they have no problem disclosing the APR of their loans. More transparency and less math is always a good thing!