Payday loans are expensive and no one in the world doubts that. The APR rates for payday loans can be as high as 4200%, definitely signaling that someone is making a fortune out of them.
However, the APR rate does not show the entire picture. Short-term lending is always expensive especially when the amount is ridiculously small. Imagine running a business with just a couple of employees. You will have to pay your employees, buy or rent a workplace, make necessary payments to government agencies for regulating your business, and spend money on advertising and marketing the business. With all these costs adding up to the value of service of product, there is going to be $10 margin for each unit to cover up the costs. The same thing happens when you borrow $200 from a payday loan lender. The lender charging $10 for the amount borrowed is actually paying for a place to work, for someone to process your loan, and for someone to receive the payments. This is the bare minimal setup for a payday loan lender, ignoring all the fees and marketing costs.
Suppose that you are paying $10 for loan with repayment period set at two weeks. If $10 makes 5% of the amount borrowed, annual charge (APR) will 130% without compounding. This seems massive but you have to understand that the APR is for the same money rolled over 26 times.
In the previous example, we did not add any interest. The 130% APR was only because of fixed fee charged for a loan issued for two weeks. This is one of the major reasons that APR goes that high- the fixed fee.
Usually people are confused since they are used to bank loans. They see the APR in comparisons to bank loan without considering the nature of both loans. Payday loans are personal loans with a short-term commitment. Lenders will only lend a small amount, usually one third of your pay. Due to this very nature of the payday loans, their annual charge become gigantic despite the fact that these loans are not expensive when viewed in the right time-frame and amount borrowed.
Payday loans are unsecured loans. This means that borrower does not have to provide anything for collateral security. This increases the risk at the lender's side, which gets the reward for risking the money by charging high interest rate and fee.
People with bad credit can also get payday loans. This means that lenders do not even have credit history to rely on. The only thing lenders have is your pay. Lender issuing a loan will ask you to provide a proof of your regular job and pay. It will only loan out the amount that you can afford to pay, known as 'responsible lending'. Since most payday lenders follow this principle, they ensure that people with ability repay are the ones getting the loan. Even if the interest rate and APR is high, it should not affect the borrower as long as the lender practices 'responsible lending'.
Remember, every loan is expensive. With payday loans, you pay one time fixed fee that can look massive when computed along with interest rate over the period of a year. Since this makes Apr, people are often confused. In fact, you pay the fixed fee with almost every loan. Since regular loans are long-term, you do not have to multiply the one-time fixed fee with anything to get annual charge. However, payday loans come with a short repayment date so extending it to a year would mean computing the fixed fee over a period it was not intended for. To get the clearer picture, you should only check the rates for the period amount is borrowed.
