Critics of the payday loan industry are quick to make the claim that payday lenders charge exorbitant fees for their loans, citing examples of loans saddled with triple-digit interest rates. But when you compare the fees imposed by other financial institutions, such as banks, credit card companies and utility companies, you soon find out that the fees associated with a payday loan are not out of line with other forms of credit.
A payday loan is a small dollar, short-term loan that the borrower typically uses to pay for an unexpected expense, like a car repair or medical bill. The borrower takes out the loan and is obligated to repay the principal plus a flat fee when they next get paid, usually in two weeks. The fee attached to the loan averages around $15 for a $100 loan.
The interest rate on a loan like this is 15%. So how do critics make the claim that payday loans involve excessive interest rates, often in the hundreds of percent? They base that claim on the annual percentage rate, or APR, that would apply to a payday loan if the borrower were to theoretically keep the loan open for a whole year.
You’re probably familiar with the APR as a measure of interest paid on a loan. Credit card companies use it and you’ve also seen it printed on advertising for new cars. It’s a perfectly legitimate and helpful way to calculate interest on a long-term loan. That’s because it measures the amount of interest someone pays on a loan over the course of a year.
The APR is calculated by multiplying the installment total by the number of payment periods in a year. So to get the APR for a payday loan of $100 loan we multiply 15 (the fee) times 26 (the number of two-week periods in a year), giving us 390.
That seems like a lot of interest—390%— to pay on a loan, but keep in mind that no one takes out a payday loan for 12 months. Government regulations and the industry’s best practices prohibit borrowers from extending a payday loan for that long.
But even if the APR gave an accurate representation of the cost of a payday loan, the yearly interest for payday loans is not that different from, and sometimes is much less than, what other forms of credit cost.
Take the bounced-check fee of $56 that a bank might charge. Apply the APR calculation we used with a payday loan to it (56 x 26), and you get an APR of 1456%. What’s more, the fees that come with overdraft protection could be much higher depending on the order in which the bank chooses to cover any outstanding checks, debit card transactions or ATM withdrawals. Also, bounce too many checks and you could lose your banking privileges altogether.
Utility companies easily charge as much as $46 in penalties and reconnection fees if you don’t pay your bill on time. If you were to have that happen 26 times in a year you’d get an APR of 1196%. Plus you’d be without gas, water and electric for varying lengths of time— maybe permanently, if the company sets an annual limit on how many times it will restart service.
Finally, fail to make a credit card payment on time and you’re looking at least a $37 late fee. Pay that every two weeks for a year and you get an APR of 962%. But that may not be all you’ll have to pay. Credit card companies might raise your normal APR if you don’t pay on time, sometimes doubling the rate. That means if you run a balance on the card you’ll also be paying a lot more in interest on your regular purchases.
Applying the APR to a short-term loan such as a payday loan doesn’t give an accurate picture of what borrowers pay in interest. But calculating the APR for what bank, credit cards and utilities charge shows that payday loans are a relatively low cost credit option.
