If you are considering taking out any kind of finance, it is important to be aware of the interest rate that comes with it.
But is there more to payday loan interest than meets the eye? And why does the APR of a payday loan look so high compared to other types of finance?
Payday loan interest rates are often quoted as exceptionally high, due to their APR.
As APR calculations are based on borrowing over a full year, they may not accurately reflect the cost of short-term loans that can be repaid in a matter of days, weeks or a few months.
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.
What is the APR of a payday loan?
Put simply, APR or Annual Percentage Rate represents the amount that your loan could cost you, over an average year.
The way the APR is calculated means that it includes interest and any additional fees (if there are any).
All lenders must publish the APR of their loans. This is a legal requirement for all loan providers, not just payday lenders.
This rule has been put in place so that consumers can easily compare the costs of different loans.
Be aware: the representative APR that you see is not necessarily the rate that you will be offered. The representative APR is the rate that at least 51% of consumers will get.
Why are payday loan interest rates so high?
Payday loans are a form of high-cost short-term credit. The reason for this, mainly, is because of the risk involved.
The majority of people who take out a loan of this type will sign up to pay back their debt over a period of days or weeks.
Lenders always need to weigh up the risks.
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.
Despite carrying out stringent affordability assessment, 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.
How is interest calculated on a payday loan?
As we touched on above, payday loan providers must publish the APR of their loans. Both interest and any additional fees (such as setup fees or monthly fees) are included in the calculation of a loan’s APR.
Many providers have a loan calculator on their website to give you an idea of what a loan could cost you.
In order to work out what the cost of your loan could be in real terms, consider calculating maximum charges and daily interest rates.
Are payday loans the most expensive form of borrowing?
Most people believe that payday loans are the most expensive form of borrowing money.
The high APR figures deter many people from applying to take out short-term finance.
However, borrowing money from an unauthorised overdraft, for example, could be costly. Fees in this instance can quickly spiral. Monthly fees can be anything from £5 to £35, sometimes more, according to the Money Advice Service. Daily fees can be more than £6 per day (with a set limit each month).
How did FCA regulations affect payday loan interest rates?
Since January 2015, price caps have been in place which means that those taking out high-cost short-term credit will never have to pay back more in fees and interest than the amount that they borrowed.
Additionally, there is a cost cap in place of 0.8% per day. This means that fees and interest of payday loans must never exceed 0.8% per day of the amount borrowed.
Default fees (sometimes charged if loans are not repaid on time) are also capped at £15.
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.