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Payday Loans and APR: What Borrowers Need to Know

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In the media, payday loans are often cited as having extraordinarily high annual percentage rates, or APRs. This is true. The average APR on a payday loan often approaches 400%. When you compare that figure to the average APR on a traditional credit card—which is typically lower than 30%—payday loans seem like a losing investment for the borrower. 

However, as it often is with statistics, the APR on a payday loan is extremely misleading. In order to understand why, and to make an informed decision on other short-term loan products, you need to have a good understanding of what the APR of a loan truly represents.

What is APR?

The annual percentage rate is, in essence, the total amount of cost that the borrower assumes when they take out a loan, divided out over the term of the agreement. Cost, for purposes of APR, includes interest, origination fees, and any other fee that the lender requires to offer the loan. This sounds a bit complex, but it is actually quite simple.

For example, imagine that you borrow $500 for one year from a friend. You agree to pay them $550 dollars total over the next 12 months. Your cost for the loan would be $50, making the APR for this loan 10%, since $50 is 10% of the amount you borrowed originally. If you were to take the same loan and terms over 2 years, the APR would be reduced to 5% due to the extra year of repayment. Essentially, APR is the amount that your lender makes on their investment each year.

The Truth in Lending Act requires lenders to accurately calculate and communicate the APR for every loan they offer. This helps consumers make accurate comparisons when determining the right loan for them—and protects the average person from hidden fees and interest schedules.

Is APR a Good Way to Compare Payday Loans?

There are a number of reasons why APR is almost irrelevant when determining the cost of a payday loan. The most important reason for this is linked with the term of the loan itself. As the name implies, the typical payday loan is designed to last only until the next paycheck that the borrower receives. In most cases, that term would be equal to two weeks or less.

To illustrate this, imagine that you took out a payday loan of $100, and you paid the institution $10 for the loan. The APR for this loan would be calculated like this:

  • $10 is 10% of the total amount of the loan
  • There are 26 two-week periods in a year
  • 10% multiplied by 26 equals 260

The APR of that payday loan is reported as 260%—not counting any late repayment fees. This appears exorbitant and unfair when compared to a credit card that reports an APR of 20%. However, in reality, the borrower is paying $10 dollars to borrow $100 for two weeks. That, on the other hand, appears perfectly reasonable.

Another significant reason that APR is invalid when assessing payday loans is linked to the fee structure of a typical credit card. Every month, when you have a balance on your credit card, you can incur late payment fees. While the first offense is capped at $25 by law, these payments can exceed $35 each month on some credit cards. Also, credit card companies can raise your interest rate after late payment fees are established—making the true APR of your credit card much higher than reported.

In spite of the way that APR makes it seem, payday loans are often inexpensive, reasonable alternatives to credit cards on small-balance loans. When used responsibly and as intended, the fee structure is reasonable and the ease of obtaining a payday loan often makes the process a superior choice to traditional credit cards. If a payday loan is something you'd like to pursue, contact a company like EZ Money.