It is broadly acknowledged that payday loan interest is high.
The high rates of interest associated with payday loans are often an easy target for many news headlines.
For many, they also act a deterrent.
People often state that they would never take out a payday loan, because of the very high-interest rates that are published. Our own research has shown that this is often through a lack of understanding and commonly held misbeliefs about the actual costs involved and lack of awareness around industry regulated price caps.
Typical payday loan interest rates
In mid-2016, Wonga (the UK’s leading payday lender) was publishing interest rates of 1,509% APR. Two other leaders, QuickQuid, and The Money Shop, were publishing 1,294% and 709% APR respectively.
The APR (Annual Percentage Rate) is calculated for all loan products and is a legal requirement for all lenders to publish this information.
The Financial Conduct Authority regulates the process that is used to calculate APR.
The Annual Percentage Rate represents the amount that your borrowing will cost, over an average year. The calculation includes interest charged, plus any additional fees such as setup fees or any monthly/ annual fees.
Simply put, the calculation for APR is the amount of interest you would pay over the course of a full year if you took a loan out for that period.
The representative APR example you will see across all consumer finance products will not necessarily be the final APR you are offered. The representative example should show the APR at least 51% of customers will achieve.
APR and payday loans
Payday loans are short term, high-interest form of credit.
This means that most borrowers will have paid their debt in a matter of weeks, sometimes a few days. As a result, the APR calculation often serves little purpose when assessing this type of borrowing.
Scaling up and compounding the cost of a short term loan over a year will make it sound much worse than it is.
Martin Lewis of MoneySavingExpert has previously addressed the issue of APR calculations that do not accurately reflect the cost of borrowing.
He calculates that borrowing £100 over one month at 1200% interest would cost roughly £25, whilst borrowing £10,000 over 25 years could cost £17,300 in interest.
In the first instance, the actual interest paid on the loan would be just 25%.
In the second example (despite the low headline interest figure of 10%) the total interest paid over the lifetime of the loan is 173%.
No wonder people are so confused when it comes to calculating interest and the cost of borrowing on a loan.
A better way to view payday loan interest?
It is best to work out the cost of a payday loan in real terms, looking at the amount that you will pay in total over your actual repayment period.
To do this, consider calculating daily interest rates and maximum charges.
The FCA (industry regulator) introduced a number of caps that are in place to protect consumers.
One of these is a daily interest rate cap, set at 0.8% per day.
This is 80p per £100 borrowed, per day.
Over the course of an entire a month, borrowing £100 would result in a total repayment of £124 (or just 24% interest on the loan itself).
In addition to the interest rate limit, the FCA has ruled that total loan costs are capped at double the amount that was originally borrowed. This means that if you borrow £100, you will never pay back more than £200 for your loan.
As you can see, the annual calculations used for the APR can be very misleading and often irrelevant
Can APR calculations ever be useful?
APR can be a useful way to compare like for like. This means that you can use the APR to determine which is the most affordable loan, comparing two that are exactly the same length and for exactly the same amount of money.
The loans must be identical for a comparison using APR calculations to be effective. APR is higher if the loan term is shorter. You will also find that making a small change to the loan term, even adding one day, can have a big impact on the amount repayable.
Why is payday loan interest so high?
Annual Percentage Rates aside, the interest on a payday loan is still relatively high. The reason for this, mainly, is because of the risk involved.
Borrowers tend to use payday loans as a last resort, in an emergency and when they do not have other credit options to fall back on. These might be people that have outstanding debts elsewhere or have been turned down by other loan providers.
Lenders always need to weigh up the risks.
They must carry out stringent affordability assessment ensuring that the borrower can afford, on paper, to pay back what they owe.
Despite this, consumers that rely on payday loans are a high-risk category.
In order to mitigate the risks of providing short-term loans to a high-risk category, lenders charge higher levels of interest.
Whether we like to admit it or not all lenders, be it the established high street banks, credit card companies or short term loan providers all run a business that needs to be profitable.
If short-term lenders charged rates of interest traditionally associated with standard ‘longer term’ loan products – e.g. 10% APR, they would earn less than £1.00 on a £100 loan and there would be no commercial viability to provide the service.
With short-term lending, as with credit over a longer period of time, borrowers are individually assessed and will usually receive a quote with an interest rate that is tailored specifically to their risk level.
Do payday loan interest rates make them the most expensive form of borrowing?
It is a commonly held belief that a payday loan is the most expensive form of credit.
Consumers often over-exaggerate the risks of payday loans, whilst underestimating the costs of other borrowing options.
You might choose to avoid a payday loan, even when you have no alternative, because the APR figures and the reputation of these loans have deterred you from applying to borrow money.
If you instead fell into in an unauthorised overdraft, you might find that you’d pay a lot more.
Unauthorised overdraft – a more expensive form of borrowing?
A Halifax unauthorised overdraft comes with a £5 per day charge, up to a maximum of £100 per month. This charge comes into play as soon as you go over your bank account’s limit. You could pay £100 for borrowing as little as 1p for a month.
If you borrow from a payday lender for 30 days, you can expect to pay back £124. If you instead went £100 into an unauthorised overdraft, you would be required to pay £200.
In addition, whilst payday loan repayments would only ever amount to a maximum of £200 for this specific loan, with a bank account you could continue to be charged £100 a month until you could afford to pay back what you owed.
Interest rates before and after the FCA regulations
Today, interest rates for payday loans rarely go above a representative 1,500% APR.
Satsuma, as of mid-2016, was amongst the lenders with the highest representative APRs, at 1,575%.
Prior to the FCA’s introduction of limits and restrictions, representative APRs were significantly higher. A BBC Consumer report in 2013 stated that they were typically between 1,000% and 6,000%.
Technological advancements have also opened up more flexible borrowing options, including something of a cross-breed between credit cards and payday loans. SafetyNet Credit offers one such option, with revolving credit in the form of small loans paid directly into a consumer’s bank account, with no minimum or maximum repayment terms.
In SafetyNet Credit’s particular case, the APR as of mid-2016 stood at 68.7%. As with other payday loans, interest is set at 0.8% per day.
With SafetyNet, it is also capped at 40 days so that consumers will never pay back more than £32 of interest on a £100 loan.
Payday loan interest summary
Payday loan interest rates are higher than many other types of borrowing in order to mitigate the risks associated with short-term emergency loans.
Despite this, interest rates are often misunderstood. Consumers typically focus on high APR figures that are quoted in advertisements (as a legal requirement).
These APR calculations, based on borrowing over a full year, do not accurately reflect the cost of short-term loans that are typically paid back within a month or two.
Payday loans are also subject to a number of caps, implemented by the FCA to ensure that interest rates are kept at a reasonable level.
These include a daily cap of 0.8% and a total cap of 100% for the original loan amount. This means that a consumer will never pay back more than double what they originally borrowed.
When considering the cost of borrowing, it is best to think in real terms.
Most lenders provide calculators on their website so that you can see exactly how much you will pay for the amount that you are choosing to borrow. Also bear in mind that some other forms of credit, such as unauthorised overdrafts, can be much more expensive overall.
Payday loan interest rates for most lenders today are between 500% and 1,500% APR for short term loans. These figures, however, are only useful when comparing exact like-for-like loan offerings.
These figures, however, are only useful when comparing exact like-for-like loan offerings.