Calculating Payday Loan Interest Using the APR: A 700 Club With No Members

Over the last few years a controversy has been brewing in some states over the rates charged for payday loans. Critics have alleged that lenders have charged up to 700% for a loan.

Reasonable regulation that prohibits exorbitant interest rates is worthy of support. But it should be pointed out that all this begs the question: Did payday lenders ever actually charge 700% for a loan?

You might be surprised to learn that the answer is no, they didn't. The fact of the matter is not a single customer who took out a loan from a reputable lender ever actually paid 700% in interest for their loan.

So how can proponents of capping interest rates on loans claim they did? That's an interesting question and one that sheds some light on how interest rates have been presented.

First some background on payday loans. A payday loan is a short-term, small dollar loan. Borrowers take out the loan and agree to pay it back on their next payday, usually in 14 days. They also have to pay a flat fee for use of the loan. Those fees can vary between lenders but a typical cost for a $100 loan in many states is $15.

You'll see that if borrowers pay $15 for a $100 payday loan they are in effect paying only 15% in interest. That amounts to a perfectly reasonable rate. So how did critics of payday lending arrive at the astronomical rate they cite?

To get there they have to apply the annual percentage rate, or APR, to the loan, which produces a much different rate than what the customer actually paid.

You're probably familiar with the APR as a measure of interest paid on a loan. Credit card companies use it and you've also seen it printed on advertising for new cars. It's a perfectly legitimate and helpful way to calculate interest on a long-term loan. That's because it measures the amount of interest someone pays on a loan over the course of a year.

But when the APR is applied to a short-term loan, like a payday loan, it presents a distorted picture of the interest a borrower is really paying.

The APR is calculated by multiplying the installment total by the number of payment periods in a year. So to get the APR for a payday loan of $100 loan we multiply 15 (the fee) times 26 (the number of two-week periods in a year), giving us an interest rate of 390%.

Now, that's a pretty high number, much more impressive than saying you're paying $15 for a $100 loan.

But the real problem with using the APR in terms of temporary loans is no one ever keeps a payday loan out for a whole year. Lending industry best practices and state regulations simply don't permit it to happen.

The number of times a borrowers can extend payday loans is heavily regulated in all states. Some states won't allow a loan to be extended even one time. And in states that do permit extensions, the number of times it can be done is limited.

This is why using figures like the 700% number don't give an accurate picture of the conditions that prevail in the payday lending industry and such tactics don't serve to encourage constructive debate on how to extend credit to underserved communities.