Calculating APR

photo by Scott Maxwell

OppLoans quoted me in How (and Why) to Calculate the APR for a Payday Loan. It reads, in part,

Sure, you may know that taking out a payday loan is generally a bad idea. You’ve heard a horror story or two about something called “rollover”, but if you’re in a jam, you might find yourself considering swinging by the local brick-and-mortar payday loan store or looking for an online payday loan. It’s just a one-time thing, you tell yourself.

It only gets worse from there… Once you start looking at the paperwork or speaking with the sales staff, you see that your payday loan will cost only $15 for every $100 that you borrow. That doesn’t sound that bad. But what’s this other number? This “APR” of 400%? The payday lender tells you not to worry about it. He says, “APR doesn’t matter.”

Well, let’s just interrupt this hypothetical to tell you this… When you’re borrowing money, the APR doesn’t just “matter”, it’s the single most important number you need to know.

APR stands for “annual percentage rate,” and it’s a way to measure how much a loan, credit card, or line of credit is going to cost you. APR is measured on a yearly basis and it is expressed as a percentage of the amount loaned. “By law, APR must include all fees charged by the lender to originate the loan,” says Casey Fleming (@TheLoanGuide), author of The Loan Guide: How to Get the Best Possible Mortgage.

But just because a loan or credit card includes a certain fee or charge, you shouldn’t assume that it’s always going to be included in the APR. Fleming points out that some fees, like title fees on a mortgage, are not considered part of the loan origination process and thus not included in APR calculations.

“Are DMV fees connected with a title loan? Some would say yes, but the law doesn’t specify that they must be included,” says Fleming.

According to David Reiss (@REFinBlog), a professor of law at Brooklyn Law School, “the APR adds in those additional costs and then spreads them out over the term of the loan. As a result, the APR is almost always higher than the interest rate—if it is not, that is a yellow flag that something is amiss with the APR.”

This is why it’s always a good idea to read your loan agreement and ask lots of questions when applying for a loan—any loan.

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Why is the APR for payday loans so high?

According to David Reiss, “The APR takes into account the payment schedule for each loan, so it will account for differences in amortization and the length of the repayment term among different loan products.”

Keep in mind, that the average term length for a payday loan is only 14 days. So when you’re using APR to measure the cost of a payday loan, you are essentially taking the cost of the loan for that two-week period, and you’re assuming that that cost would be applied again every two weeks.

There are a little over 26 two-week periods in a year, so the APR for a 14-day payday loan is basically the finance charges times 26. That’s why payday loans have such a high APR!

But if the average payday loan is only 14 days long, then why would someone want to use APR to measure it’s cost? Wouldn’t it be more accurate to use the stated interest rate? After all, no one who takes out a payday loan plans to have it outstanding over a full year…

Short-term loans with long-term consequences

But here’s the thing about payday loans: many people who use them end up trapped in a long-term cycle of debt. When it comes time for the loan to be repaid, the borrower discovers that they cannot afford to pay it off without negatively affecting the rest of their finances.

Given the choice to pay their loan off on time or fall beyond on their other expenses (for instance: rent, utilities, car payments, groceries), many people choose to roll their loan over or immediately take out a new loan to cover paying off the old one. When people do this, they are effectively increasing their cost of borrowing.

Remember when we said that payday loans don’t amortize? Well, that actually makes the loans costlier. Every time the loan is rolled over or reborrowed, interest is charged at the exact same rate as before. A new payment term means a new finance charge, which means more money spent to borrow the same amount of money.

“As the principal is paid down the cost of the interest declines,” says Casey Fleming. “If you are not making principal payments then your lifetime interest costs will be higher.”

According to the Consumer Financial Protection Bureau (CFPB), a whopping 80% of payday loans are the result of rollover or re-borrowing and the average payday loan customer takes out 10 payday loans a year.

Reiss says that “the best way to use APR is make an apples-to-apples comparison between two or more loans. If different loans have different fee structures, such as variations in upfront fees and interest rates, the APRs allow the borrower to compare the total cost of credit for each product.

So the next time you’re considering a payday loan, make sure you calculate its APR. When it comes to predatory payday lending, it’s important to crunch the numbers—before they crunch you!

Wednesday’s Academic Roundup

Reiss on High Loan Fees

CRM Buyer quoted me in On-Premises Banks Stick It to Walmart Customers. It opens,

Walmart customers who use the banking services provided inside the chain’s stores are among the highest payers of fees — especially overdraft fees — in the U.S., a Wall Street Journal analysis of federal filings concluded.

The five banks with the most Walmart branches ranked among the top 10 U.S. banks in fee income as a percentage of deposits last year, the paper reported, compared to other U.S. banks that earn most of their income through lending.

It is a notable finding, especially given Walmart’s brand: First and foremost, the company has built a reputation for providing low-cost products at significant savings compared to other stores.

Walmart cannot be held completely responsible for the banks’ practices, of course. The financial sector is highly regulated, and no third-party retailer is in a position to set standards or make policies.

However, Walmart told the Journal that it has a thorough process for vetting banks to make sure they are in line with its philosophy.

Financial Reform? What Financial Reform?

Apart from the Walmart branding issue, the report highlights some other concerns. In spite of curbs on financial industry practices in the last few years, it still is possible for providers to levy high fees on consumers in the lowest economic brackets, making it more difficult for them to work their way out of debt. A new government agency, the Consumer Finance Protection Bureau, was established to curtail such activities. Why do they still occur?

The Wall Street Journal leads off its article with the story of a consumer who knowingly overdraws her checking account to pay for a needed car repair. The US$30 fee, which translated into an APR of more than 300 percent, was actually cheaper than a payday loan, the borrower said.

In the bank’s defense, there are certain financial, market, regulatory and business realities that cannot be ignored.

“While I am not going to defend high-cost fees for financial products, I would say that the lenders often have high fixed costs for each transaction that can work out to a higher percentage of the amount borrowed than they would be for larger transactions,” David Reiss, a professor at Brooklyn Law School, told CRM Buyer.

“So, I would say that there is some gouging going on in this market, but also some basic business reality,” he remarked.