By: Javi Calderon
Looking Inside the Math of Payday Loan APR Rates
Much of the criticism against payday loans focuses on the gaudy looking triple-digit APR numbers that activists and politicians point to in order to give the impression that lenders are charging astronomical rates for short-term loans.
APR, or annual percentage rate, however, is what the interest rate would be if the typical 14 or 30 day loan was rolled over throughout the entire year and the interest was compounded. Its pretty obvious that no one is actually paying 300% or 400% interest on their loan, that just doesn’t make sense. Therefore, APR is not an accurate or fair representation of the actual interest that a short-term payday loan typically carries.
Lets do some quick math:
Let’s say that the cost of operation for a payday lender is a flat $10 per loan. This is to cover employee salaries, rent, utilities, equipment, etc. So, if someone takes out a $200 two-week loan, $10 is only 5% of that loan – not at all unreasonable. However, if you use APR to calculate the rate, 5 multiplied by 26 (because there are 52 weeks in a year) comes out to a whopping 130% APR. Without even adding interest we are already in triple digits!
Lenders also have to include a fee in order to mitigate losses from people who default on their loans. After all, it doesn’t make much sense to lend money if you’re not being paid back. Around 6% of payday advance loans end in default. So, pretty simply, a 6% fee is tacked on to make up for these eventual losses.
To calculate the APR for a two-week loan you multiply 6 by 26, and come out with 156%. Without adding any fees, charges or interest to actually make any money, a lender has to charge around 286% APR just to break even! This awful sounding number, however, only comes out to $22 on a $200 loan, barely over 10%.
For lenders to actually make a profit, obviously, they have to add yet another fee or rate. As you can see, lending and borrowing money for short amounts of time is simply expensive, and there’s no way around that. On the other hand, when borrowing and lending large amounts of money for longer periods of time, for example a mortgage loan, these fees get dispersed along the life of the loan and therefore become negligible.
As you can see through the math above, holding lenders to 36% APR, as many states are doing, doesn’t even allow them to cover their overhead, and only results in the extinction of the industry in that state. Cash advance loans have found a niche, and are in demand by people who are struggling to make ends meet and are hampered by bad credit in this tough economy. We all just need to understand and come to terms with the fact that lending and borrowing money short-term is expensive, and find ways to support the industry while still protecting consumers.