Payday Loans + APR = Very Bad Idea

The following guest post is from Jeff Rose. Jeff is a Certified Financial Planner in Illinois, authors the blog Good Financial Cents and is currently working on his first book Soldier of Finance.

I’m not shy about talking about payday loans. In other entries to my blog, you’ve heard me condemn them up and down, backwards and forwards. (Trust me. I’m not done yet.) I’ve even put them near the top of my list of financial Weapons of Mass Destruction. I can’t say enough about how destructive this kind of lending is. They don’t call it predatory lending for nothing, that’s for sure.

I’ve laid out before a number of reasons why payday loans are a flat out bad idea, so I thought I’d use this entry to go into deeper detail about maybe the most important part of what makes payday loans such a rip off.

The APR. Trust me, it’s absolutely, positively, astronomical.

The Basics of APR

I don’t want to assume everyone knows what I mean by APR, so let me frame it up for you quickly before I get too deep into why payday loan APRs are so horrible. Stick with me for a minute, and I promise – you’ll be able to see for yourself why payday loan APRs are not to be messed with.

APR stands for annual percentage rate. In summary, this is the rate at which your loan accrues interest. In plainer English, this is the amount of money you have to pay beyond what you were loaned. To the person who loaned you the money, this is the profit.

Simply having an APR isn’t bad. Most forms of credit and most loans are made profitable through an APR. It’s a necessary part of the credit industry.

What makes payday loan APRs so ridiculous is how high they are. Percentage rates on these are many many times higher than most other forms of credit reinforcing why you need to avoid payday loans at all costs.

Typical Loan APRs

As I mentioned, most forms of credit have an APR. The difference between traditional forms of credit (like mortgages, credit cards, student loans, etc.) and payday loans is that most traditional forms of credit have at least a somewhat reasonable APR, and a payday loan has an exorbitant APR.

For example, a typical credit card’s APR is somewhere between 7% and 36%. Now, I know that’s a big range, but it goes to show you where someone who doesn’t have good credit would be placed – out at the upper end of the 30% range. Please don’t get me wrong – that’s not, by any stretch of the imagination, a good rate. If you have credit cards at that rate, it might make sense to talk to someone about consolidating your debt. Our current Visa carries a rate of 9.99%, but also remember that we pay it off each month.

For a second example, a car loan APR is usually somewhere between 5% and 15%. 15% is certainly on the very high end, but again – I bring it up because it’s an excellent example of typical APRs, and will help to show you just how ludicrous payday loan APRs are.

As a third example (and then, I promise, I’ll show you some actual examples of payday loan APRs), let’s consider mortgage rate prices from January 2010 through to the end of October 2010. Over that period of 10 months, mortgage rates ranged from 5.21% to 4.19%. Keep that in mind as we move on.

It’s worth mentioned that car and mortgage loans are usually for large sums of money, so lenders can afford to charge a lower rate. They still make plenty of money. 4.19% of $200,000 is $8,380, and that’s before you take compounding into account. Not too bad for a few days work.

Some Actual Payday Loan APRs

How does 521% sound? That was the stated APR for a lady that I met with that was struggling with her debt. The was the highest rate she had, with the others all being above 300%. If you ask me, it sounds absolutely ridiculous. And that’s not even the highest it goes. Payday loan APRs can range from about 390% to 780%.

Did your jaw hit the floor yet? Well pick it up and make this promise to me and to yourself right now.

“I promise to NEVER get a payday loan. I promise to remember that there are other options, and to explore what they are before making drastic decisions about my finances.”

Trust me, they simply aren’t worth it.

Comments

  1. I cannot tell you how many of my young sailors have gotten into trouble with these forms of loans. It’s especially true of younger sailors, but I’m sure some of the older ones have done it too. They “need” cash for the weekend before payday, go to the place that’s way too close to base for my comfort level, and get a loan for way too high interest. We hold training on it all the time, how to avoid them, etc, but still some fall for it. Thanks for this post.

    • I used to work at a bank in an Army town and I saw much of the same. These places tend to pop up near bases, and in areas with a poor and/or elderly population.

  2. My jaw hit the floor at “typical credit card’s APR is somewhere between 7% and 36%”.

    … could anyone lend me an oil drill? I would like to get it back before it will munch out to China ;)

  3. Those people that prey on others with predatory practices are generally doing so on those that have no other options. People who take payday loans are not middle or upper class people most of the time. These are people who are about to lose the family apartment, which means homelessness and in some places losing their children as a result. Predatory towing often takes place in much the same manner. They prey on working class citizens who need the car for work the next day or face losing their only source of income. So called legal protection clauses are jokes in these industries. They typically protect the merchant.

  4. Just a note about your statement: “4.19% of $200,000 is $8,380, and that’s before you take compounding into account.”

    Mortgages don’t compound. At each and every moment, the interest is always paid up, so there’s no interest on interest. Let’s just be clear!

    • Derek above is correct in this instance. Mortgage loans are made on a P&I basis, that is principal and interest, so that you have the same payment month to month. In the begining of the loan your monthly payment comprises mostly interest and very little principal, but this style of lending guarantees that all interest due on the loan is paid monthly.

      Therefore, like Derek mentioned here, there is no compounding of interest on mortgage loans, the amount of interest you pay each month actually slowly decreases over the life of the loan as you pay it down. Good catch Derek.

      • That 521% can be misleading. Unlike car and mortgage loans that are for years at time. Pay day loans are biweekly or monthly most of the time. So for example if I borrow 500 until my next pay day the interest will be somewhere around 20%. So on your next pay day you will owe me 600. Now you have the option to pay the loan and renew it again or just pay it and never borrow again. If i did this every pay period for a year then yes I would be paying that outrageous amount. The problem with these loans is that if you make the same on your pay check and you are behind now you will always need the loan and be behind. Most of this takes place in African American communities along with liquor stores ( another subject)

  5. Granted the APR is high, but if you have the money to lend these people and want to take the credit loss risks, go ahead. Otherwise, stop the bashing of these credit products and offer an alternative form of short term credit.

  6. This all used to be called loan sharking and was illegal. Guess that all changed with the subprime loan mess.

  7. Wow. 521%? 300%? I saw a commercial on TV for a Native American financial institution. The claim was “we aren’t cheap but we’re cheaper than a payday loan.” My morbid curiosity sent me to the website and was over 100%. Around 110-120%, I believe. And I thought that was nuts (well, for those of us in the real world, it is). Holy crap.

    • Trust me. I couldn’t believe it either. I seriously thought it was a typo.

      What was even crazier is that the lady knew it was 521% and she still went through with it.

  8. bhoshamwow… I agree there is really nothing illegal about these places/products. But I do think they are predators of a sort. Just like other forms of credit, people don’t know how to use them wisely and end up getting themselves into real trouble. Like I said in my earlier comment, places like these are all the more reason why it is good to have a small ‘emergency stash’ on hand.

  9. I agree that payday loans are bad news, but here are some nitpicky corrections:
    APR is not the same as the interest rate. APR is a formula created by government in an effort to provide an apples to apples comparison between loan products. It works well for large amounts and long terms (cars or houses) where costs and fees (which are included as “interest” in the calculation) are small relative to the loan amount. For a payday loan, where the amounts are small, the term is short, and the costs large relative to the loan amount, APR is not so useful. The cost for a bank to process a car loan is not too far off from a payday loan: some teller time + some paperwork, say $10. Then spread the same cost over a $20,000 car loan vs a $200 payday loan as a percentage

    Also, interest paid is not profit. First the interest has to cover the processing cost, overhead, cost of funds, and risk of default. What is left after all this is profit. Payday lenders do transactions that bankers don’t want to touch, and the actual $ profit per transaction can’t be that large.

    That said, consumers shouldn’t do payday loans because they are expensive – an emergency fund is a much better idea.

  10. These loans are predatory, but the people who use these services do not have choices because they do not have bank or savings accounts. Some of it is due to the culture of poverty. It makes no sense to pay those high fees, but they make poor choices. I am on a campaign to change this by teaching financial literacy in high school and established a personal financial blog (www.krantcents.com) to spread the word.

  11. I expect everyone has heard (some may even have said) “Lend me $20 until I get paid next week? I’ll buy you a beer on payday.”

    That’s $20 lent for a week with zero interest but with a $3 lending fee – over 140,000% APR.

    It’s important to remember that APRs are designed to make the comparison of *similar* financial products simpler. It’s a great way to shock you into how much short-term credit really costs though!

  12. Payday loan interest rates are pretty high, yet most people who use them believe they have no choice because there’s a bill that urgently needs to be paid. Yet most of the time the providers of whatever service needs to be paid for (that is, the landlord or the gas company) don’t really want to lose a customer because of the cost associated with replacing that customer with someone else. Evictions, for example, are very expensive. So are repossessions and foreclosures. Service providers may talk tough, but the only time it’s in their interests to truly “fire” a customer is if they’re being systematically jerked around, if they’re really not being paid, or if they have reason to believe the customer could pay but elects not to. For an otherwise good customer, they’re just as likely to assess a late fee. This late fee is generally less than the cost associated with a payday loan.

    I don’t suggest that anyone abuse the late fee concept or take advantage of individuals or companies that provide services, but there’s often room for negotiation.

    • You are correct on everything you said. However, I’d like to clarify that in my post above I stated that these people are already *at* the end of the rope. They have for whatever reason (be it bad choices or unfortunate circumstance) already pushed the lender they are trying to pay (the bill) to the limit. This means the lender has already taken them to eviction and they are within the 30 day required grace period (a Virginia law), the service is to be shut off immediately because they are at the last extensible date, or if they don’t pay child support today they go to jail tomorrow, etc. It’s not a middle or upper class thing (we usually have something as collateral, or credit, or a fund). Payday loans are marketed to the poor and impoverished. It *is* loan sharking. My wife, who works for a church, sees the mess it causes daily. Rarely does it ever make sense. If people only did it when it made sense, the payday loan companies would probably dry up, but the people who use them have usually already used up the first lenders good grace.

      • They may have used up the lender’s good grace, but whatever pain they’d feel as a result of not paying is generally less than what they’d feel as a result of being on the hook to a payday lender. When the situation is as dire as you describe, a payday loan only postpones the inevitable. It also postpones the recovery from whatever disaster the payday loan is intended to prevent.

        In many states, there’s an extra vicious angle to a payday or car title loan. The lender does not accept partial payments and the loan must be repaid in full, plus any additional service charges. Of course, for a fee, the lender will gladly renew the loan. But not a cent of this fee goes to the principal the way it would, say, on an outstanding credit card balance. Nor will the lender accept so much as a cent toward reduction of the principal, unless the initial loan and all fees and interests are paid in full as a lump payment. Very few people can do this on a limited income, so once they’re on the hook, they tend to stay there.

  13. I was trapped by payday loans. I would pay them off every pay day, then by the end of my pay period a “need” would pop up (I would just run out of money). I kept trying harder and harder to be conservative, but I just couldn’t shake the whole process. I was stuck.

    This is how I got out of it: when I got my Christmas bonus I paid off the current payday loan and threw away my checkbook. I ripped up ALL my checks. That way I had to just live within in my means. I know I’m not the typical person that one thinks of when it comes to this discussion, but that’s my experience.

  14. People are grossly exaggerating the importance of the high apr in whether these loans are exploitative or not. You must also consider the fact that these loan amounts are relatively small. If I borrow $5 from a friend on sunday to pay for a happy meal at mcdonalds, then pay back $6 the next day, I will have paid back 7,300% on that loan. Wow that’s such a ripoff! How could your friend exploit you like that!
    No, it could very well be a good deal for me if there was no other way for me to eat at that time and if I had to go back home for money because I left my wallet there.
    Here’s an actual example: I was late on the rent for my apartment last month and I had to pay $75 extra on $1000 rent for being late 4 days so I paid $1075. Now that is exactly as if the landlord gave me a loan of $1000 on the day rent was due and charged me $1075 4 days later. What is the apr on that ‘loan’? 684%. So if payday loans are bad, let’s make hundreds more laws outlawing exhorbitant late fees for renting stuff.

    My point is that just looking at the apr and nothing else about the loan is extremely misleading.

  15. We knew when we borrowed $400 from cashloancity.com it wasn’t going to be free, but it saved our butt. You can’t compare APR on an emergency loan.

  16. I got stuck in a payday loan for 14 months borrowing £600 each month and paying back £767 . The original loan was for £400 but slowly some how built up because I seem to always need that bit extra and finally when I got to the £600 mark paying it back plus the interest of £167 left me with an up hill struggle as soon as i got payed each month as it was almost half my wages so I borrowed again and again .i suppose I could have asked a family member or friend but like most people in that situation I felt very embarrest to talk about it .however I have managed to break the chain by hard work doing ,as much overtime as possible and getting ahead I have been free now for 3 months and would advice anyone to be very careful when thinking of taking out any loan of this sort.I made a very big mistake which brought nothing but worry and misery for 14 months .

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