Payday loans are meant to be a short term funding option to help people cover expenses in between pay periods. Because the loans are generally small, and the terms are so short, these loans can come with high fees. Even though the pricing of a payday loan can be high, it is quite straightforward with no complex credit or background checks required.
Payday lenders commonly defend their high rates by explaining that they provide a service more traditional lenders refuse to provide. Because most traditional lenders and major financial institutions do not feel it is in their best interest to issue short term loans for low amounts, payday lenders have no choice but to maintain their high prices in order to manage their personal loan processing expenses. For example, if a payday lender were to price a loan the same way a bank would price a large loan, a $125 two week loan with an annual percentage rate (APR) of 15% would result in just 58 cents of interest. This would not even come close to covering the processing costs of the loan.
For the most part, each individual state establishes restrictions on just how high lenders can set their rates. Most states have very strict usury limits in place that prevent any lender from exceeding a particular annual percentage rate (APR). Other states do not set specific limits, while a few states ban the practice of payday lending all together.
To help you gain a better understanding of exactly how the process of payday lending works, and how much this form of a loan really costs, consider this example: A person needs to borrow $450 for a two week period. The payday lender agrees to provide the funds in return for the borrower providing a postdated check in the amount of $517.50. This amount covers the $450 that was borrowed, plus a $67.50 interest charge, when assessed at a rate of 15%. The lender then holds the postdated check for two weeks. Once the two weeks has elapsed, the borrower must repay the money, have their check cashed, or request the loan to be renewed. If the loan is renewed, the first $517.50 must be repaid right away, after which a new loan for the same amount will be issued for another two week period.
It is also important to consider the cost of the total APR and effective annual rate (EAR) when dealing with a payday loan. The difference between the APR and EAR can be considerable because the EAR is compounded. To give you an idea of just how much this can cost, let's take a look at an example. A person borrows $200 for two weeks with an interest rate of 15%. The APR for this loan would come out to be 390% (15% interest x 26 weeks). EAR is calculated a bit differently using the following formula: EAR = (1 + R/P)P - 1, where R is the interest rate, and P is the number of compounding periods. For the above example, the EAR calculates out be 3,685%.
As you can see, while they can be quite handy, payday loans can add up quickly. It is always best to use them carefully and only when absolutely necessary.
