Perils of Payday Loans
What is a Payday Loan?
Short-term loans, often called "Payday Loans," are loans with a very short payback period. Payday loans often have a 14-day payback period, which is usually the time until a borrower's next paycheck, hence the term payday loan. For some, this kind of loan can look very useful, as it allows you to get cash upfront and pay down the cost of the loan when you have money available. Although helpful, these loans usually have a very high interest rate associated and can quickly become far more expensive than one originally thought.
To understand the cost of a Payday Loan, let's compare the Annual Percentage Rate (APR) on the loan. The APR is the annual interest rate that you would pay on a loan. Payday Loans are often misleading because the loan is only for two weeks. So, the yearly interest is often not taken into account. However, once the annual interest is understood, the cost of a Payday Loan is staggering compared to other forms of debt.
Calculating the APR on a Payday Loan Requires 5 steps:
1. Calculate the total interest paid:
For example, on a $500 loan from Money Mart, you would pay $75 in interest.
2. Divide your interest payment by the value of the loan:
In the above example, we would divide $75 of interest by the $500 loan value. This gives us an interest rate of 15%. This is the percentage of interest on the loan.
3. Divide the loan interest rate by the payback period.
The typical payback period for a Payday Loan is 14 days. So, 15% divided by 14 is 0.0107%. This is your daily interest rate.
4. Multiply the daily rate by 365.
To compare the Payday Loan on an annual basis, we need to multiply the daily interest rate by 365 days in a year. Continuing with the above example, 0.0107 multiplied by 365 days is 3.910. To turn this number into a percentage rather than decimal, multiple by 100. Therefore, the annual percentage rate on a $500 Payday Loan from Money Mart is 391%. To put this in perspective, the typical APR on a credit card is 18%.
APR rates for different loan amounts are highlighted below. All loan amounts below have a 14-day period.
All of this information was taken directly from Money Mart Loan Calculator.
As shown in the previous example, Payday Loans are one of the most expensive forms of debt. Therefore, they should never be used unless absolutely necessary. Payday Loans are designed to keep people in debt. While this may look like quick cash, the cost to borrow that “quick cash” is extreme. Unfortunately, this often creates a negative feedback loop. If you require a Payday Loan, it is because your paycheck was not enough. As a result, once your 14-days are up, chances are you will need another loan, and you will be stuck paying that loan plus interest indefinitely.
For example, suppose you require a $500 loan every two weeks. In that case, you will also be stuck paying an additional $75 in interest every two weeks. Over a year, you will have paid $1,950 in interest. This also does not include the fact that you may not be able to cover the interest expense. If you need to take out more than $500 on the following loan just to cover the previous loan, then the interest will quickly snowball out of control.