Tag Archives: payday loan

Calculating APR

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photo by Scott Maxwell

OppLoans quoted me in How (and Why) to Calculate the APR for a Payday Loan. It reads, in part,

Sure, you may know that taking out a payday loan is generally a bad idea. You’ve heard a horror story or two about something called “rollover”, but if you’re in a jam, you might find yourself considering swinging by the local brick-and-mortar payday loan store or looking for an online payday loan. It’s just a one-time thing, you tell yourself.

It only gets worse from there… Once you start looking at the paperwork or speaking with the sales staff, you see that your payday loan will cost only $15 for every $100 that you borrow. That doesn’t sound that bad. But what’s this other number? This “APR” of 400%? The payday lender tells you not to worry about it. He says, “APR doesn’t matter.”

Well, let’s just interrupt this hypothetical to tell you this… When you’re borrowing money, the APR doesn’t just “matter”, it’s the single most important number you need to know.

APR stands for “annual percentage rate,” and it’s a way to measure how much a loan, credit card, or line of credit is going to cost you. APR is measured on a yearly basis and it is expressed as a percentage of the amount loaned. “By law, APR must include all fees charged by the lender to originate the loan,” says Casey Fleming (@TheLoanGuide), author of The Loan Guide: How to Get the Best Possible Mortgage.

But just because a loan or credit card includes a certain fee or charge, you shouldn’t assume that it’s always going to be included in the APR. Fleming points out that some fees, like title fees on a mortgage, are not considered part of the loan origination process and thus not included in APR calculations.

“Are DMV fees connected with a title loan? Some would say yes, but the law doesn’t specify that they must be included,” says Fleming.

According to David Reiss (@REFinBlog), a professor of law at Brooklyn Law School, “the APR adds in those additional costs and then spreads them out over the term of the loan. As a result, the APR is almost always higher than the interest rate—if it is not, that is a yellow flag that something is amiss with the APR.”

This is why it’s always a good idea to read your loan agreement and ask lots of questions when applying for a loan—any loan.

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Why is the APR for payday loans so high?

According to David Reiss, “The APR takes into account the payment schedule for each loan, so it will account for differences in amortization and the length of the repayment term among different loan products.”

Keep in mind, that the average term length for a payday loan is only 14 days. So when you’re using APR to measure the cost of a payday loan, you are essentially taking the cost of the loan for that two-week period, and you’re assuming that that cost would be applied again every two weeks.

There are a little over 26 two-week periods in a year, so the APR for a 14-day payday loan is basically the finance charges times 26. That’s why payday loans have such a high APR!

But if the average payday loan is only 14 days long, then why would someone want to use APR to measure it’s cost? Wouldn’t it be more accurate to use the stated interest rate? After all, no one who takes out a payday loan plans to have it outstanding over a full year…

Short-term loans with long-term consequences

But here’s the thing about payday loans: many people who use them end up trapped in a long-term cycle of debt. When it comes time for the loan to be repaid, the borrower discovers that they cannot afford to pay it off without negatively affecting the rest of their finances.

Given the choice to pay their loan off on time or fall beyond on their other expenses (for instance: rent, utilities, car payments, groceries), many people choose to roll their loan over or immediately take out a new loan to cover paying off the old one. When people do this, they are effectively increasing their cost of borrowing.

Remember when we said that payday loans don’t amortize? Well, that actually makes the loans costlier. Every time the loan is rolled over or reborrowed, interest is charged at the exact same rate as before. A new payment term means a new finance charge, which means more money spent to borrow the same amount of money.

“As the principal is paid down the cost of the interest declines,” says Casey Fleming. “If you are not making principal payments then your lifetime interest costs will be higher.”

According to the Consumer Financial Protection Bureau (CFPB), a whopping 80% of payday loans are the result of rollover or re-borrowing and the average payday loan customer takes out 10 payday loans a year.

Reiss says that “the best way to use APR is make an apples-to-apples comparison between two or more loans. If different loans have different fee structures, such as variations in upfront fees and interest rates, the APRs allow the borrower to compare the total cost of credit for each product.

So the next time you’re considering a payday loan, make sure you calculate its APR. When it comes to predatory payday lending, it’s important to crunch the numbers—before they crunch you!

The State of Predatory Lending

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By U.S. Treasury Department (CFPB Conference on the Credit Card Act, 02/22/2011) [Public domain], via Wikimedia Commons

The Center for Responsible Lending has posted the final chapter of The State of Lending in America: The Cumulative Costs of Predatory Practices. This chapter’s findings include,

  • Loans with problematic terms or practices result in higher rates of default and foreclosure/ repossession. For example, dealer-brokered auto loans, which often contain abusive provisions, are twice as likely to result in repossession as bank- or credit union-financed auto loans.
  • The consequences of default, repossession, bankruptcy, and foreclosure are long-term. For example, one in seven job-seekers with blemished credit has been passed over for employment after a credit check, and borrowers who experience default pay much more for subsequent credit.
  • The opportunity costs of abusive loans are significant. For example, during the same period that subprime loans peaked and millions of families unnecessarily lost their homes, families with similar credit characteristics who sustained homeownership experienced on average an $18,000 increase in wealth per family.
  • Abusive loans have an impact on the economy as a whole. The foreclosure crisis depleted overall housing wealth and led to millions of job losses; predatory practices have been shown to diminish public trust and confidence in the financial system; and there is evidence that student debt is preventing economic growth, especially for young families.
  • Across many financial products, low-income borrowers and borrowers of color are disproportionately affected by abusive loan terms and practices. Families with annual incomes below $25,000– $35,000 are much more likely to receive an abusive loan product. And in most cases, borrowers of color are two to three times more likely to receive an abusive loan compared with a white counterpart. The discriminatory effects of abusive lending clearly contribute to the widening wealth gap between families of color and white families.
  • Loans with problematic terms are repeatedly concentrated in neighborhoods of color. Subprime mortgages and payday loans are two examples. Such concentration leads to a net drain of community wealth and value that could have been spent on productive economic activity and meeting vital community needs.
  • Debt plays a profound role in the financial lives of most American households, with about three-quarters of households having at least one form of debt and many having multiple forms of debt. Indeed, most consumers are not simply mortgage holders, credit card users, payday loan borrowers, or car-title borrowers; they are likely to participate in more than one of these markets, often at the same time.
  • Regulation and enforcement is an effective means for ending lending abuses while preserving access to credit. For example, the Credit Card Accountability and Disclosure Act of 2009 (Credit CARD Act) has continued to give people access to credit cards, while eliminating more than $4 billion in abusive fees and overall saving consumers $12.6 billion annually. (6-7)

The Center for Responsible Lending is a very effective advocate for consumer protection in the financial services industry. That being said, I found it interesting that they were very circumspect in their section on Future Areas of Regulation. (33) They referenced the existing Credit CARD Act, Dodd-Frank Act, state payday lending laws and federal payday lending regulations, but they did not identify any aspects of the consumer financial services market that need additional regulation. Hard to imagine it, but it seems that CRL believes that we have reached regulatory Nirvana, at least in theory.