When you take out a payday loan, you might notice that the APR is significantly higher than the simple interest rate advertised. This can be surprising, but understanding how APR is calculated and why it’s higher than the interest rate can help you make informed financial decisions.
APR vs. Interest Rate
The interest rate represents the cost of borrowing as a percentage of the loan amount over a specific period. It’s a straightforward number that lenders advertise to show how much you’ll pay for borrowing, excluding other fees. However, the APR goes a step further by including all additional costs associated with the loan, such as origination fees, processing fees, or other charges. This means the APR provides a more comprehensive view of the loan’s total cost.
For payday loans, the discrepancy between the interest rate and APR is primarily due to the short repayment term. Payday loans are often due within two weeks, and when the costs are annualized to calculate the APR, the resulting percentage becomes significantly higher. In essence, the APR reflects the true cost of borrowing if the loan were extended over a year, which explains why it appears so much higher than the advertised interest rate.
How Is APR Calculated?
To calculate the APR, lenders consider the total cost of the loan, including interest and fees, relative to the loan amount and the repayment period. The formula involves converting the short-term cost into an annualized rate to standardize comparisons across different loan products. Here’s a simplified explanation:
- Calculate the total cost of borrowing (interest and fees).
- Divide this cost by the loan amount.
- Adjust for the loan term (in days) by dividing by 365 and multiplying by 100 to express it as a percentage.
Example Calculation
- You borrow $100 with a $15 fee.
- Repayment is due in two weeks (14 days).
Daily cost: $15 ÷ 14 days = $1.07 per day. Annualized cost: $1.07 × 365 = $390.55. APR: $390.55 ÷ $100 (loan amount) × 100 = 391%.
This high APR reflects the short-term nature of the loan and highlights how costly payday loans can be compared to other credit products.
Why Does APR Matter?
The APR is a valuable tool for comparing the true cost of borrowing across different types of loans. While payday loans are designed for short-term use, their APR reveals the high cost of borrowing if the loan were extended over a year. Here are some key points to consider:
- Payday Loans vs. Credit Cards: A $100 payday loan with a 391% APR costs $15 for two weeks. By contrast, a $100 credit card with a 30% APR costs about $1.25 for two weeks.
- Payday Loans vs. Installment Loans: Installment loans typically have lower APRs and longer repayment periods, making them a more affordable option for larger amounts.
Tips for Managing Payday Loan Costs
- Focus on APRs: Use APR as your benchmark when comparing payday loans with other credit products.
- Explore Alternatives: Consider installment loans, credit cards, or personal loans, which often have lower APRs and more flexible repayment terms.
- Borrow Only What You Need: Minimize borrowing to reduce the total cost of the loan.
- Repay Quickly: Paying off a payday loan as soon as possible can help you avoid rolling over the loan and incurring additional fees.
Conclusion
Understanding the difference between APR and interest rate is crucial when evaluating payday loans. The APR reflects the true cost of borrowing and allows you to compare payday loans to other credit products. While payday loans can provide quick access to cash, their high APRs make them one of the most expensive borrowing options. By focusing on APR and exploring alternatives, you can make more informed financial decisions that better suit your needs.