Payday loans typically attract consumers who have low credit scores, which make them high-risk borrowers. In order to compensate for this risk, payday loan lenders will offer these prospective borrowers with loans that have a very high annual percentage rate (APR).
What is an APR?
An APR refers to the rate of interest that a borrower will pay to their lender when they take out a loan. It is calculated as an annual percentage, even though payday loans are typically only short-term loans.
An APR will represent the annual cost of funds for the lender. The lender is then able to choose whether they would like to add on any further fees to charge the borrower.
What is the Difference Between the Cost of Funds and APR?
The cost of funds refers to how much money a financial institution needs to pay in order to obtain funds. The lower the cost of funds, the greater the return will be for the lender when lending the money.
Thus, the difference between the cost of funds and the APR incurred by borrowers will be where the majority of financial institutions make their money. Before making the decision of whether or not to lend, lenders will assess the cost of funds to see how profitable it is for them.
What is the Average APR for a Payday Loan?
Payday loans are known for having extremely high APR rates. The exact APR will differ from lender to lender.
The average APR for a payday loan lies around 400% per $15 to $100 borrowed. Compared to 12-30% for credit cards, this rate is extremely high.
What is the Maximum APR That a Payday Loan Lender Can Charge?
Payday loans are legal in 37 US states, and some of these have imposed an interest cap on the lenders. However, the majority of these states permit payday loans with no restrictions or legislation. In these states, such as Texas and Nevada, the APRs on payday loans can reach up to between 390 to 780%.
Why is the APR for Payday Loans so High?
Payday loans operate on a short-term basis and are deemed to be relatively high-risk. Some reasons as to why they are so high include:
- Payday loans are unsecured loans
Payday loans are unsecured. This means that unlike other loans such as a title loan, there is no collateral attached to the loan. As such, if the borrower defaults on their repayments, the lender is unable to repossess any of their assets to make up for this loss in value to them. Consequently, payday loans are high risk loans for the lenders.
- Payday loans attract borrowers with low credit scores
Payday loan lenders typically do not carry out hard credit checks. This means that the loans may attract those who have previously been in debt or have defaulted on a number of loans. As such, since payday loans may be their only option, lenders are able to charge higher APR.
- Payday loans are not usually repaid on time
More than any other loan, payday loans are often not repaid by their borrower. Around 15 to 20% of borrowers have not repaid their loan by the repayment date, with a quarter of payday loans re-borrowed a minimum of 9 times.
