Payday Loans, APR and You

During the last week or two, the financial industry has been seen in the news quite a bit. Most of what's being talked about is investing and mortgages.

However, it seems that as finances take center stage in the politics of this country, it will only be a matter of time before payday loans become the target of scrutiny and lobbyists once again.

Certain states have already banned payday loans outright. They feel the high APR is completely unjustified and a danger to consumers. Some states do allow payday lenders, but they have very strict regulations.

Other states, very few of them, allow payday lending with very little regulation. Lobbyists are working hard on both sides to either ban these short-term loans, or heavily regulate them to be "consumer friendly."

A payday loan, or cash advance, is a short-term loan designed to be paid back by your next payday. To understand payday loans better, we should become acquainted with the language of lending.

Principal- this is the initial amount of money borrowed by the consumer.

Term- this is the amount of time a borrower has to pay back the loan, plus interest.

Interest- the fee assessed by the lender to the borrower for the service of lending the money.

APR- Annual Percentage Rate; in other words, the percentage of the principal paid in interest in 1 year

Now let us examine how a lender can make money by handing it out. If a consumer borrows $500 on Monday and gets paid on Friday, then the term of the loan is five days. Interest is always measured in APR regardless of the term, so let's say the APR is 350%.

The consumer who borrowed $500 on Monday will pay their lender about $525 on Friday. The consumer had their money when they needed it and the lender was paid $25 for providing the consumer their money at the time they needed it.

About this APR- it's really not that scary to think about. Lobbyists are the ones who pushed to get interest measured in APR only so that it would hurt payday lenders. Let's take a closer look.

An APR of 350% sounds astronomical in the minds of most consumers. But keep in mind the "A" stands for "Annual." This means that over the course of 12 months, you will end up paying 350% of the principal. That is a lot. But what's not a big number here is the term. It's only five days. Payday loans are designed to be fourteen days or less.

Now suppose that you took APR and changed it to DPR- Daily Percentage Rate. An APR of 350% translates to roughly 1% DPR. This means that every day of the term costs you 1% of the principal. That sounds a lot better than 350%, right?

So assume the consumer had their loan for ten days instead of five. They still only pay $50 in interest, or 10% of the principal. This is what the payday loan critics don't want you to know.

Let's go ahead and examine a bank loan. Suppose a consumer receives a $5,000 loan from the bank, with a term of five years. The APR is only 20% (wow, what a deal!) so the consumer thinks this surely is a good deal.

Well, if every year the consumer pays 20% of the principal, that's $1,000 a year in interest. Over five years, how much has the consumer paid? The $5,000 principal and then another $5,000 in interest. That means the consumer ended up paying 100% of the principal in interest. And banks and their lobbyists want you to believe that payday lenders are ripping people off? For shame...

So remember, when considering payday loans, you have to look at just one thing- how much will this cost me in interest? If you pay back the loan in just a few days, chances are you are only looking at paying 10-20% in interest.

Don't be fooled by the government mandated APR posted in the windows. That is there because lobbyists want to scare you away from a payday lender. You will end up paying far more in interest at a bank or credit union than you would at a payday lender.

There's nothing wrong with shopping around and getting the best rates for a loan. Just don't compare the APR of a payday lender and a bank. The loans they offer are very different. It's like apples and oranges. All you need to do is look for reputable lenders in your area or online, then compare their rates.

Go with the lender that can offer you the best deal. If you are smart enough to be reading this and doing your homework on payday loans, then you are smart enough to see through the APR trickery of the banks and their lobbyists. Don't let them fool you.