When you are in a difficult financial situation, applying for a payday loan can seem like the only solution. These short-term, high-interest loans are easy to be accepted for and can give you money in your bank account within minutes. They are designed to bridge the gaps between pay checks or help out if you find yourself with some emergency expenses.
If you have ever looked into getting a payday loan, you might have noticed that all lenders will advertise an APR for the loan. For payday loans, this APR is usually very high, often a percentage in the hundreds or even more. This guide explains why payday loans charge such a high APR, and how to properly understand your payday loan costs.
What is APR?
APR stands for Annual Percentage Rate and indicates the annual rate that is charged for borrowing. It is the official figure used for comparing all types of financial products, including payday loans, mortgages and credit cards. It is a legal requirement that every loan must present their rates in the form of APR, in order to make it easy to compare the costs of various lending products.
As APR is calculated using the annual measures of interest on a loan, it is an excellent indicator for long-term finance products such as mortgages or long-term loans.
APR differs slightly to interest rates which you may also see advertised with some lending products. An interest rate refers only to the interest that will be charged on a loan and does not include any additional fees or charges that you might incur. APR is the combination of interest rate and any other fees and costs involved in obtaining the loan or credit. Because of this, APR is almost always higher than the interest rate as all additional fees and charges are included.
A representative APR refers to the rate of interest that the majority of customers will receive. This representative APR is likely to vary depending on the duration on the loan being taken out.
How does APR work for payday loans?
The interest that you will pay on a payday loan generally won’t change in any way, or be made up of various different factors, unlike with longer-term loans and mortgages. When you are looking at the APR for a long-term finance product, it can get very complicated very quickly. This is because there are often lots of different fees involved and different interest rates will be offered depending on an individual’s financial situation.
Credit cards can also make APR confusing, as your interest will be compounding on a daily basis. Compounding interest means that your interest charges are added to the amount borrowed, and therefore you will then be charged further interest on this interest.
With payday loans, there is no need to worry about compounding interest or lots of additional fees. The interest that you pay on a payday loan is often referred to as the finance charge and is an easily calculated fee that is based on how much you want to borrow and for how long. For example, you might be charged a finance charge of £20 for every £100 borrowed for seven days, which in APR terms would be 1042.85% as APR is calculated on an entire year.
To calculate the APR of a payday loan, you should first divide the finance charge by the loan amount. Then times the result by 365 days to calculate the full year, and then divide by the length of the loan. Finally, times this number by 100 to get the APR.
Why is the APR so high for payday loans?
Payday loans APR are always a very high number compared with other financial products, and the reason is that APR refers to the annual charge and payday loans are only designed to be very short-term. The average length of a payday loan is just 14 days, and when you work out the APR for that two-week loan, you are assuming that the same cost would be applied every two weeks for the entire year.
As payday loans are types of short term loans, it can make using APR to measure the cost very inaccurate as you would never have a payday loan for a full year. It is important to bear this in mind when comparing financial products and deciding which is right for you.