States, like Utah say that annual interest charged on payday loans is gradually declining – from 474 percent last year to 466 percent this year. According to Utah officials, borrowers pay and average of $17.93 every two weeks for every $100 dollars borrowed. If you take that number and multiply it by 26 two weeks periods in a year, you get what’s known as the annual percentage rate or APR. In this case, 17.93 multiplied by 26 is 466.18 percent.
But the debate rages on about whether APR is a fair way to measure the cost of an ultra-short term loan like a payday loan. Borrowers are supposed to pay the loan back in two weeks. If they do, they end up paying less than 18 percent per $100 borrowed. (17.93 is less than 18 percent of 100).
When APR Is a Good Measure
APR is a good measuring stick for the costs of loans like mortgages, car loans or even credit cards. Most borrower carry balances on these loans for at least two years and many times longer. Auto loans can run 60 to 72 months these days and home loans can last up to 30 years. So knowing how much interest you’re paying per year is a helpful tool for a long-term loan.
However, when you apply APR to short-term loans it can mislead the public into the thinking the loans cost more than they really do.
Limiting APR To 36 Percent
Many consumer advocates want to cap payday and other short-term loans at 36 percent. They see this as the highest acceptable interest limit for any kind of loan. But, here’s the problem. While, this may make sense for revolving loans, such as credit cards or even installment loans, like auto loans, it is confusing when applied to payday loans.
Let’s look at an example. If you divide 36 by 26 you get $1.38. That means a lender would have to extend a very risky loan and only earn $1.38 per $100 loaned out. No business in its right mind would take this risk for amount. It doesn’t make business sense. Most astute businesses understand the tradeoff between risk and reward and they take on higher risk if they have the potential to earn more money.
Here’s What Will Really Happen If Loans Are Capped
So here’s what so called consumer advocates and policy makers will really accomplish. They’ll remove these loans from the marketplace and limit consumers’ choices. This will end up costing those in a bad financial situation more – not less.
What happens if those with emergency financial needs can’t get the cash they need? That’s fairly easy to predict. They will resort to other more expensive options, including bouncing checks, which can have an APR of 3,000 percent. Most banks charge $29 to $35 for an overdraft even if the debit or check only runs a few dollars. This is much more harmful then a short-term payday loan.
Or they will lose vital services such as electricity or water. Not only will they go without the service, they will also pay costly reconnection fees and maybe even a deposit. This can hurt them much more than paying 36 bucks to borrow $200 until they get their next paycheck and pay the loan.
Why Payday Loans Are Misunderstood
Sure, we’ve all heard the horror stories of those who keep rolling over payday loans and racking up fees, but not everyone handles the loans that way. And the truth is most borrowers are not the bad financial situation they are in because of having access to payday loans. It is a much larger problem – and it want be solved by limiting their access to emergency cash.
Part of the misunderstanding about payday loans comes from the fact that many of the policy makers have never truly walked in the shoes of those who take out the loans. Payday borrowers don’t have credit cards, savings, or a cushy retirement account. Bad or non-existent credit scores have limited their loan options.
All they have for collateral – so to speak – is a job and a paycheck.
These borrowers are not stupid and they don’t need to be protected by someone who treats them that way. Typically, the borrower knows they are choosing the least expensive of a few “not so great” options. They “get” that they’re paying a premium for the money, but understand it is still cheaper than the alternatives.