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Annual Percentage Rate (APR) of Payday Loans

Annual Percentage Rate (APR) of Payday Loans

Many critics of payday loans point to the very high annual percentage rates (APRs) of cash advance loans compared to the APRs of other loans such as mortgages. However, looking at the APRs isn't a very useful way to compare payday loan companies, once you understand what APR means.

To understand what APR means and what it was designed to be used for, you can read the informative article on Annual Percentage Rate in the Wikipedia, the free online encyclopedia.

The APR is meant to be the effective interest rate for a loan, and is supposed to take into account the various fees and finance charges, along with the interest rate for the loan. The purpose is to have an apples to apples comparison of different loans, so you can easily choose the one with the lowest total cost.

This is very useful when you are picking out a home mortgage or car loan, where a lender may try to make a loan look cheaper by showing the monthly or daily interest, rather than the annual interest rate. Another way to make a loan look cheaper would be to have a lower interest rate, but make it up by charging points, higher origination fees or prepaid interest. Therefore, for these complicated loans, having the APR to compare them is very useful.

Most payday loans are simple. You generally pay a flat charge per $100 borrowed. This makes it easy to compare cash advance companies, since obviously the one that charges $15 per $100 is cheaper than the one that charges $20 per $100 if the other terms are the same. So using an APR to compare cash advances is not useful, and actually makes things more complicated and very confusing.

In fact, even calculating the APR of a short term loan such as a cash advance loan isn't so simple. Just about all the formulas and annual percentage rate calculators out there need the number of years of the loan as a positive integer. Therefore, you cannot even use them to calculate the annual percentage rate for a payday loan that is only for a couple weeks.

Critics are right that the effective interest rates for cash advance payday loans are indeed high. While many could still argue that the rates are too high, there are clearly many legitimate reasons why they would be high relative to other credit instruments.

It is natural that the effective interest rate for a very short term loan will be higher than that of a long term loan, especially if you are including all fees in the calculation. Likewise, borrowing when there is significant collateral, such as with a home mortgage or car loan, should have much better rates than when there is 0 collateral. In addition, borrowing when good credit is required should have much lower rates than with no credit checks, where you can be accepted even with bad credit or no credit.

In summary, while the APR is a useful way of comparing one mortgage to another, it is not very useful for comparing different cash advance offers. Annual percentage rates can be somewhat useful way of comparing payday advances to other types of loans, but there are reasons why the APRs will be significantly different.

Posted by Cash Advance Planet
Apr 27, 2006 2:04 pm

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