A new survey by the Consumer Finance Association (CFA) shows just how widespread American consumer confusion is regarding the true cost of their payday loans. Although it is understood that cash advances incur much less red tape to apply for and receive than other loans, a high number of consumers are perplexed by interest rate figures that give an incorrect picture of how much the loan will cost them to borrow.
1 in 4 consumers do not understand that payday loans are less expensive than they think
Less than ¼ of consumers surveyed by the CFA were able to select the correct answer when they were asked to calculate how much it cost to borrow $100 for one month from a payday lender. The confusion arose from applying the lending industry standard Annual Percentage Rate (APR) calculation.
Why is APR misleading?
The APR calculation is annualized, meaning that the percentage rate given is calculated on the basis of the loan being borrowed for 12 months of the year. Payday loans are, on average, short-term loans that are borrowed in the United States for anything from 10 to 31 days in length, not 365 days which is the basis upon with the APR is calculated.
The true cost in cash
The truth is that a payday loan of $100 charged at a 25% interest rate would be only $25 – much cheaper than many consumers surveyed thought. While the monthly interest figure is 25% in the example, the annualized figure is 650% APR – yet this yearly percentage calculation is highly misleading.
Cash terms of interest shows payday loans to be cheaper
$25 dollars to borrow $100 sounds much more manageable and is more accurate, representing the real amount a consumer will pay to borrow the $100 over 31 days. As such, the CFA believes that spelling out borrowing costs in cash terms helps demonstrate that payday loans are much cheaper to borrow than previously thought under the APR framework. The CFA has stated that the continued use of APR calculations when giving quotes on payday loan finance rates leads to the payday loan industry receiving “unfair criticism” for receiving interest percentages in the hundreds and thousands.
Payday loans may be cheaper than one year loans
12-month lenders, with loans that are available for the full duration of the year, in fact offer a more expensive option than payday loans, available for 10 days to 31 days. Although some calculations of payday loans with APRs of 5,800% in U.S. states with no interest rate cap may sound absurd, those figures are not representative of the much smaller amount of cash interest applicable to the 4-week loan. However, when compared to a 12-month loan charging 299% APR, it becomes apparent that this longer option is substantially more expensive. For example, a loan of $1,000 from a 12-month lender that is borrowed for 365 days with 12 payments of $158.19 equals 278 APR.
Beware of 12-month loans
Consumer action groups have stated that one-year loans should be treated with caution as they are highly expensive ways to borrow money and can have an impact on credit scores due to the outstanding debt remaining for 12 months, rather than just a few weeks with a payday loan.
Therefore, according to the CFA, when used responsibly and repaid in full by the end of the loan term, a cash advance for a number of days or weeks represents a more affordable and less committed way to borrow in the short term, without the colossal APR that is misleadingly attached to it.
Have you been confused by APRs in relation to payday loans? Do you think that payday lenders should more clearly explain how their finance charges operate in cash rather than using the industry standard APR calculation? Tell us what you think by leaving us a comment, below!