How Is The Interest Rate On a Payday Loan Calculated?

A high-interest-rate payday loan is considered a shining example of high-risk predatory loans in America. The average interest rate on a payday loan is about 400% and can even exceed 600%! But why are rates on payday loans so high? And how is the interest rate on a payday loan calculated?

Of course, you can use a loan calculator to make things easier. But sometimes, it’s useful to understand how the cost of the loan you need to repay is formed. To answer all these questions, let’s start with how payday loans work and what factors can affect payday loan interest rates.

How Does a Payday Loan Work?

A payday loan is a short-term cash advance that was created for borrowers with low credit scores. Unlike loans from traditional financial institutions, payday loans have simple eligibility criteria, a straightforward submission process, and prompt loan verification.

As most payday loan lenders go above and beyond to make obtaining a cash advance a thing you can complete with your eyes shut, they don’t check your credit score through major credit bureaus. Thus, we need to keep in mind that payday loans are a type of emergency financial assistance for people with poor credit or those who need money right this second.

Payday loans range in sums between $100 and $1,000. You can get a payday loan online without wasting time and leaving your home or workplace. Payday loan lenders typically transfer money to a borrower’s bank account within 24 hours. As these urgent options are not designed to cover your long-term needs, you need to repay the entire loan balance in one lump sum by your next paycheck.

So, we typically speak about a two-week payday loan, but it can also have loan terms up to 30 days. And your repayment date is usually the moment when payday loan interest rates come to play. Payday cash advances are unsecured loans.

Thus, you don’t need to provide a lender with any guarantee. It’s also a loan that is available with any credit score, so it comes with the risk of default which lenders strive to prevent. That is why most payday lenders set up higher interest rates compared to loans from a bank or credit union.

Therefore, get ready to repay an extra $10 to $30 per each $100 obtained. At first glance, it seems like a small amount that everyone can afford. But if you know how to calculate it right, you will see that an annual percentage rate can reach the triple digits. Thus, the high cost of payday loans is determined by their accessibility, quick cash options, and payday lenders’ risks.

What Is an Average Payday Loan Interest Rate?

It is considered that payday loans always have a very high interest rate. In fact, there is a deal of truth with it if you calculate it on an annual basis. Payday loans have one of the highest APRs among all the other financial obligations. Therefore, they are banned in some states or are subject to strict state lending law regulations.

An average loan till payday comes with about 400% APR, which is extremely high. For example, an APR on an installment loan may be between 16% and 100%. Also, many credit unions and banks offer personal installment loans with an average 9.5% APR, while credit card companies set up an average of 20% to 30% on their cash advances.

Thus, payday loan borrowers overpay ten times more than people who can access traditional loans. At the same time, you need to repay the loan by the next payday, so terms usually don’t exceed 30 days. Therefore, this method of calculation rather shows how much you would potentially pay to the payday lender if you used the loan within the whole year.

What Determines Payday Loan Interest Rates?

Interest rates on payday loans depend on several factors. First of all, it’s the particular lender and the state you apply in. Some payday lenders may also pay attention to your income, debt-to-income ratio, or debt utilization rate. However, there are other factors that can explain the high cost of payday loans.

Collateral backing

As payday loans are unsecured and don’t require any collateral, lenders put themselves at risk in case of any problems with debt settlement. Thus, in order to minimize potential money losses, they set up higher rates. 

The cost of funds

Any financial institution pays a cost for the funds they obtain to lend them to you further. The lower the cost, the lower APR a lender can offer. As the difference between the cost of funds and the amount of finance charge they get from a borrower is the main source of income for any financial institution, it also plays an important role. Payday lenders pay a high price for the funds they provide, so an APR is also expensive.

Risks

Payday loans were designed mostly for people with bad credit. They were created to be accessible and fast, but, as we all know, there will always be a trick. Typically, a payday lender doesn’t perform a hard credit check of your credit report. It means that it uses alternative sources to check your credit history.

Such a credit check doesn’t leave any records in borrowers’ credit reports. Therefore, the payday lending industry is packed with high-risk borrowers who can’t access traditional personal loans as well as guarantee they will turn back the money on time. So, lenders just strive to protect themselves by setting high interest.

Loan terms

Payday loans have short repayment terms, while an APR determines the amount you will have to pay if you use the loan within the whole year. Thus, when you calculate the APR on payday loans, it turns out to be extremely high.

How to Calculate an APR on Payday Loans?

A payday loan APR is calculated in several steps. First, you need to take the amount of interest you’ve paid and divide it by the amount you’ve borrowed. Thus, you’ll receive your interest rate in decimal. The next step is to multiply this figure by the number of days in the year (365) to determine an annual percentage rate of the loan.

Next, you need to divide this figure by the number of days of your loan repayment terms. The last step is to multiply the amount you get by 100 to move the decimal point to the right place. If it was confusing, don’t worry! Let’s try an example.

If you obtain a $500 loan for 14 days and are obliged to pay an extra $75 in charges, your loan APR is: $75 / $500 = 0.15

Next, you need to multiply it by the number of days of the year: 0.15 x 365 = 54.75.

Then, you need to divide this figure by the number of days of your loan term: 54.75 / 14 = 3.91.

The last step is to move a decimal point by multiplying by 100 to get the percentage: 3.91 x 100 = 391%.

Thus, payday loans are a shining example that even a finance charge that seems low can add up to an APR of about 400%.

What Are The Types of Interest Rates?

Whatever loan you choose, interest rates will always haunt you. On the face of it, they are all the same. For an average customer, interest is just the amount they need to pay all at once or month by month in addition to the loan principal. By the way, interest rates really determine your loan’s cost and the sum a payday lender will get from you for lending you money.

However, there are various types of interest rates that payday lenders or other loan providers can apply. And yes, the type of interest rate affects both the amount of your payments and how much you will have to repay in total. Typically, interest rates can be divided into fixed or variable and simple or compound.

Fixed Rate

A fixed rate is a predictable quantity that doesn’t change. Thus, you can be sure your loan payment won’t vary and will be the same each month. As you always know how much you need to pay, it makes budgeting convenient and easy. You can clearly plan your spending and don’t worry about unexpected amounts that come with the changes in interest rates by big banks.

Variable Rate

A variable rate means that your loan interest can change from month to month. Variable interest usually depends on current market conditions and financial situation, so you never know whether you will pay more for the next month or will be able to save money. Sometimes loans at variable rates can help you pay less, but you need to be ready for small financial fluctuations from one monthly payment to another.

Simple Rate

A simple rate is called so because you can simply calculate it on your own. When a lender offers a loan with simple interest, it means it uses only your principal balance to calculate it. As it’s so clear and easy to figure out, many bank loans and cash advances from credit unions have a simple rate. But payday lenders use it too. The most popular types of personal loans with simple rates are installment loans and bad credit personal loans.

To calculate a simple rate, you can use the following formula:

Your total interest amount = (P x I x T) / 100,

where P is for your principal loan amount, I is for your interest rate in percentage, and T is for your loan term in years. You can also convert your interest rate from percentages to decimals to exclude dividing by 100.

Compound Rate

If a lender uses a compound rate, it means it calculates interest by using not only your principal balance but also the interest accumulated in previous periods. It means that your loan can become extremely expensive rapidly as the interest accumulates in a number of compounding periods. It can happen monthly, quarterly, semiannually, or annually. Here is a formula that can help you calculate the amount of interest paid for a compound-rate loan:

 P (1+r/n)nt – P = Interest amount,

where P is for your principal balance, r is for interest in decimal, n is for the number of compounding periods within the year, and t is for the loan term in years.

What Is An Annual Percentage Rate?

An annual percentage rate (APR) is the amount that a lender earns from an average borrower within one year. It represents the annual amount of interest paid by the principal loan amount you’ve obtained. The APR includes not only an interest rate but also any other fees a lender charges.

The APR is usually divided by the number of your monthly installments, so you pay both interest and your principal loan balance each month.

What Are Predatory Lenders?

People often classify payday lending as predatory. A predatory lender is a name for a loan provider that gets financial gain from vulnerable people who are in desperate situations. Thus, payday loans and tribal payday loans are considered the face of predatory lending. Typically, such loan providers have the following similar features:

There are now several acts created to protect borrowers from any criminal actions in the payday lending field. For example, the Military Lending Act, which restricts interest for active service duty members over 36%, or the federal Truth in Lending Act. Also, some states have their own lending law regulation that caps interest rates or even bans payday lending.

What Happens If I Don’t Repay Payday Loans on Time?

When you can’t keep up with your loan payments and the due date is fast approaching, you need to contact your lender and ask for available options. Although one missed payment is not the end of the world, it can lead to unpleasant consequences. First of all, it can lower your credit score by a few points. Also, a lender may turn to a debt collector or make a wage garnishment to withdraw money directly from your bank account.

Thus, you’d better notify the lender in advance. Some lenders can offer you debt management plans that can make your short-term loan easier to repay the loan. Also, a lender may offer you a rollover, but you should think twice before accepting it. Rollovers often come with higher fees, so you can easily get into a payday loan trap.

What Are Payday Loan Alternatives?

Cash advance apps

A cash advance app works similarly to payday loans, but they are not the same. You can get the money till your next paycheck but with a lower fee. Also, a loan amount you can obtain will be limited to a percentage of your next wage.

Auto title loans

Consider a title loan if you have a car to use as a pledge. You can get up to 50% of its value and repay the money back in 30 days. Otherwise, you risk losing your vehicle.

Traditional loans

If you have good credit, you can seek help from traditional financial institutions. However, such loans come with more requirements and have longer-lasting application and verification processes.

Bottom Line

So, how is the interest rate on a payday loan calculated, and is it affordable? The question seems to be simple, but the answer is not so clear. Even if it seems that a lender offers you reasonable fees you can afford, you should delve deeper into the topic to find out what your loan’s real cost will be. You can use the formula above to calculate an APR on your loan and determine whether you obtain a favorable borrowing option.

Payday loans may be either a debt trap or an instrument to overcome a financial crisis. It depends on how you use it and whether you estimate all the risks.