A Payday Parable

Annual Percentage Rate Word of the Week

A Payday Parable

You’re applying for a payday loan, and you’re wondering why so many people are dead set against them. You check the interest rate and you think to yourself, “It says here that it’s only 15 percent. I guess 15 percent is a little high, but for someone with my credit score, this rate is fantastic!” So you sign up for the loan and go on your merry way …

Cut to three months later. You’ve had trouble repaying the loan and you’ve ended up rolling it over six times. You do the math and you realize that the amount you’ve paid so far in interest adds up to 90 percent of what you were loaned. 90 percent! In only three months! What happened to that 15 percent rate you got when you signed up for the loan? You dig out your loan agreement and you read it through again …

And that’s when you see it. Down there in the corner of the document. It says “Annual Percentage Rate: 390 percent” That’s a heckuva lot higher than 15 percent!

The True Cost of Borrowing

Whenever shopping for a loan, always make sure you check the Annual Percentage Rate, or APR. It is a standard unit of measurement in lending that will let you compare the relative cost of different loans, no matter how they’re structured. The APR measures how much a loan would cost if the principal loan amount were outstanding for a single year. It’s expressed as a percentage of the amount loaned, so a $1,000 loan that charged $100 in interest per year would have an APR of 10 percent.

What’s the Difference?

Now, you might be saying, “isn’t that basically the same thing as the interest rate?” Not quite. A loan’s interest rate is a very important part of its APR, but it’s not the whole thing. The APR measures the full cost of a loan, which means that it includes additional fees and interest above and beyond the simple interest rate. This is why financial advisors will always tell you to check the APR when applying for a loan or credit card. It’s how you know the loan’s true cost.

APRs in Payday Lending

With a payday loan, the stated interest rate only applies for the length of the loan term. So if you take a 14-day payday loan with a 15 percent interest rate, that rate only applies for 14 days. If you were to rollover the loan and secure an additional 14-day term, you would be charged an additional 15 percent. All of a sudden, the cost of your loan is 30 percent. Over the course of a full, 52-week year, a 15 percent rate every two weeks would add up to 390 percent. That’s the PAYDAY loan’s APR. And that’s ridiculously expensive.

Read more about the Annual Percentage Rate (APR).

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