How (and Why) to Calculate the APR for a Payday Loan

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Sure, you may know that taking out a payday loan is generally a bad idea. You’ve heard a horror story or two about something called “rollover”, but if you’re in a jam, you might find yourself considering swinging by the local brick-and-mortar payday loan store or looking for an online payday loan. It’s just a one-time thing, you tell yourself.

It only gets worse from there… Once you start looking at the paperwork or speaking with the sales staff, you see that your payday loan will cost only $15 for every $100 that you borrow. That doesn’t sound that bad. But what’s this other number? This “APR” of 400%? The payday lender tells you not to worry about it. He says, “APR doesn’t matter.”

Well, let’s just interrupt this hypothetical to tell you this… When you’re borrowing money, the APR doesn’t just “matter”, it’s the single most important number you need to know.

APR stands for “annual percentage rate,” and it’s a way to measure how much a loan, credit card, or line of credit is going to cost you. APR is measured on a yearly basis and it is expressed as a percentage of the amount loaned. “By law, APR must include all fees charged by the lender to originate the loan,” says Casey Fleming (@TheLoanGuide), author of The Loan Guide: How to Get the Best Possible Mortgage.

But just because a loan or credit card includes a certain fee or charge, you shouldn’t assume that it’s always going to be included in the APR. Fleming points out that some fees, like title fees on a mortgage, are not considered part of the loan origination process and thus not included in APR calculations.

“Are DMV fees connected with a title loan? Some would say yes, but the law doesn’t specify that they must be included,” says Fleming.

According to David Reiss (@REFinBlog), a professor of law at Brooklyn Law School, “the APR adds in those additional costs and then spreads them out over the term of the loan. As a result, the APR is almost always higher than the interest rate—if it is not, that is a yellow flag that something is amiss with the APR.”

This is why it’s always a good idea to read your loan agreement and ask lots of questions when applying for a loan—any loan.

APR can sometimes be a tricky measure

If you’re talking about long-term financial products like mortgages or credit cards, APR can get complicated in a hurry.

With mortgages, there can be a ton of fees involved—some of which might very well be excluded from the APR. And with credit cards, your interest usually ends up compounding on a daily basis, which means that you’ll end up paying more than the stated APR.

What does “compounding interest” mean? Well, it means that your interest charges get added to your principal loan amount, which means that you start getting charged interest on your interest. Fun, right?

One more way that APR can be misleading has to do with amortizing installment loans. With these loans, which are paid off in a series of equal, regular payments, a certain portion of each payment always goes towards your principal loan amount. As the principal goes down, the amount of money that is accrued in interest goes down too.

The APR is a measurement of the cost of a loan over its lifetime, calculated from the snapshot of the origination date.” Says Fleming. “If you were to calculate the APR over the balance of a loan midway through its term the number would be different because the advance fees and interest have already been paid. “

Payday Loan APRs are simple (and simply unacceptable)

Compounding interest isn’t something you’ll have to worry about with a payday loan. The principal stays the principal and the interest stays the interest.

And payday loans don’t amortize either. The interest you pay on a payday loan is usually referred to as a “finance charge” and it is a simple fee based on the amount you borrow. For instance, a $300 payday loan that costs $20 per $100 borrowed would have a finance charge of $60.

When considering a loan, you’ll definitely want to make sure it doesn’t include any hidden or additional fees (read more in the eBook How to Protect Yourself from Payday Loans and Predatory Lenders). Other than that, calculating the APR should be a good way to calculate just how expensive that loan is compared to your other options.

In fact, you’ll probably be pretty surprised.

How to Calculate APR for Payday Loans

When calculating the APR for a payday loan, you are going to need three pieces of information.

  1. The principal loan amount, or how much money you are borrowing
  2. The amount you’re paying in interest on the loan, also referred to as the “finance charge.”
  3. The length of the repayment term, or how long the loan will be outstanding.

Got that? Okay.

To make things a bit easier to understand, let’s use an example:

Payday Loan #1 has…

  1. A principal loan amount of $400
  2. An interest amount/finance charge of $80 (a rate of $20 per $100 borrowed)
  3. A repayment term of 14 days.

First, you’ll want to divide the interest/finance charge by the loan principal:

$80 / $400 = 0.2

This tells you how much you are paying relative to how much you are borrowing. 0.2 translates to a rate 20%, which means that you are paying a 20 cents on every dollar that you borrow.

Next, you’ll want to multiply that result by 365, for the number of days in a year:

0.2 x 365 = 73

Next, you’ll want to divide that result by the length of the repayment term:

73 / 14 days = 5.214285

That final result basically states that, if your payday loan were to be outstanding for a full year, you would pay over 5 times the amount you originally borrowed in fees and/or interest. To convert into APR, just move the decimal point two spaces to the right and add a percentage sign:

521.43% APR

(Thanks to ConsumerFed.org for this formula.)

Why is the APR for payday loans so high?

According to David Reiss, “The APR takes into account the payment schedule for each loan, so it will account for differences in amortization and the length of the repayment term among different loan products.”

Keep in mind, that the average term length for a payday loan is only 14 days. So when you’re using APR to measure the cost of a payday loan, you are essentially taking the cost of the loan for that two-week period, and you’re assuming that that cost would be applied again every two weeks.

There are a little over 26 two-week periods in a year, so the APR for a 14-day payday loan is basically the finance charges times 26. That’s why payday loans have such a high APR!

But if the average payday loan is only 14 days long, then why would someone want to use APR to measure it’s cost? Wouldn’t it be more accurate to use the stated interest rate? After all, no one who takes out a payday loan plans to have it outstanding over a full year…

Short-term loans with long-term consequences

But here’s the thing about payday loans: many people who use them end up trapped in a long-term cycle of debt. When it comes time for the loan to be repaid, the borrower discovers that they cannot afford to pay it off without negatively affecting the rest of their finances.

Given the choice to pay their loan off on time or fall beyond on their other expenses (for instance: rent, utilities, car payments, groceries), many people choose to roll their loan over or immediately take out a new loan to cover paying off the old one. When people do this, they are effectively increasing their cost of borrowing.

Remember when we said that payday loans don’t amortize? Well, that actually makes the loans costlier. Every time the loan is rolled over or reborrowed, interest is charged at the exact same rate as before. A new payment term means a new finance charge, which means more money spent to borrow the same amount of money.

“As the principal is paid down the cost of the interest declines,” says Casey Fleming. “If you are not making principal payments then your lifetime interest costs will be higher.”

According to the Consumer Financial Protection Bureau (CFPB), a whopping 80% of payday loans are the result of rollover or re-borrowing and the average payday loan customer takes out 10 payday loans a year.

Reiss says that “the best way to use APR is make an apples-to-apples comparison between two or more loans. If different loans have different fee structures, such as variations in upfront fees and interest rates, the APRs allow the borrower to compare the total cost of credit for each product.

So the next time you’re considering a payday loan, make sure you calculate its APR. When it comes to predatory payday lending, it’s important to crunch the numbers—before they crunch you!



About the Contributors:

Casey Fleming, began as an appraiser in 1979 and built one of the largest appraisal and consulting firms in the San Francisco Bay Area.  He sold the firm in 1995 to transition to mortgage lending. Casey built a team of 300 loan agents from 2003 through 2008, mentoring dozens of senior agents and producing training meetings for hundreds. After the Financial Crisis Casey wrote The Loan Guide: How to Get the Best Possible Mortgage.  to help consumers protect themselves from predatory practices. Today Casey is passionate about educating consumers.

David Reiss, is a professor at Brooklyn Law School and director of academic programs at the Center for Urban Business Entrepreneurship. He is the editor of REFinBlog.com, which tracks developments in the changing world of residential real estate finance.