In the past few years, some states have disputed the rate of payday loans. Critics alleged that lenders have charged up to 700% on loans.
Reasonable regulations prohibit excessive interest rates that are worth supporting. But it should be noted that all of this raises the question: Does the payday lender really charge 700% of the loan?
You may be surprised to know that the answer is no, they don't. The fact is that a customer who lends a loan from a reputable lender actually pays 700% interest on the loan.
So how can supporters who support the loan interest rate ceiling do it? This is an interesting question, and it provides some inspiration for how to raise interest rates.
The first is some background knowledge of payday loans. Payday loans are short-term, small dollar loans. The borrower takes out the loan and agrees to repay it on the next payday [usually within 14 days]. They must also pay a flat fee to use the loan. These fees may vary between creditors, but in many states, the typical cost of a $100 loan is $15.
You will see that if the borrower pays $15 for a $100 payday loan then they actually only pay 15% interest. This is equivalent to a perfectly reasonable ratio. So how do critics of payday loans come up with the astronomical figures they quote?
To get there, they must apply from
Annual interest rate from
, that is, APR, the interest rate generated is very different from the interest rate actually paid by the customer.
You may be familiar with APR, which is a measure of the interest paid on a loan. The credit card company is using it, and you have also seen it printed on the ads of the new car. This is a completely legal and useful way to calculate long-term loan interest. That's because it measures the amount of loan interest that someone pays in a year.
However, when applying APR to short-term loans such as payday loans, it presents a distortion of the interest actually paid by the borrower.
APR is calculated by multiplying the total amount of installment by the number of payment periods in a year. Therefore, to get the APR of a $100 payday loan, we multiply 15 [cost] by 26 [two weeks of the year] to get a 390% interest rate.
Now, this is a fairly high number, and it’s impressive to say that you have to pay $15 for a $100 loan.
However, the real problem with using APR in terms of temporary loans is that no one can keep payday loans for a full year. Best practices and national regulations in the loan industry simply do not allow this to happen.
The number of times a borrower can extend a payday loan is strictly regulated in all states. Some states do not allow the loan to be extended once. In states that allow extensions, the number of times that can be performed is limited.
This is why the use of a similar 700% figure does not accurately indicate the prevalence of the payday loan industry, and this strategy does not encourage constructive debate on how to extend credit to underserved communities.