A borrower who needs cash immediately, and knows payday is coming in the next two weeks, may think taking out a quick payday loan is a relatively harmless situation.
But a closer look shows that a payday loan rate is substantial and quite costly, according to Eric Sussman, a professor at the University of California at Los Angeles’ Anderson School of Management.
While the annual percentage rate (APR) — the interest rate charged per period multiplied by the number of periods per year — on payday loans may seem modest, things change when looking at the rate from a yearly perspective, Sussman said.
“When you annualize the rates, you realize that after first glance what appears to be a modest interest rate appears to be fairly onerous,” Sussman said.
For example, paying $115 for a two-week loan of $100 appears to be a payment of 15 percent interest.
But that $15, when compounded over 14 days, brings the APR to a whopping 391.07 percent.
The effective annual rate (EAR), a tool that helps compare loans with different APRs that are compounded at different frequencies (annually, monthly, daily, etc.), further illustrates the staggering cost difference: The EAR for the $100 loan is 3,724 percent.
A comparison to borrowing with a regular monthly credit card at a department store further illustrates the actual costs of a payday loan. If that card’s APR is 17 percent, about what most cards are at, then the EAR is 18.39 percent.
“I think payday loans, and again I don’t want to say [they] are the most expensive loan, but they are way up there and, from my perspective, modes of last resort,” Sussman said. “You should not need a payday loan unless you absolutely have no alternative source of capital from somewhere. I would try other means if I could, because those APRs are significant.”
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