Why do we use APR?

Borrowing money can be confusing. Banks and payday lenders and other lenders will throw out a lot of numbers that may mean different things. The Truth in Lending Act was a federal act that, among other things, required lenders to quote the APR to someone who is considering taking out a loan. They did this, ostensibly, to reduce some of the confusion in the marketplace.

What is APR?

APR lets you look at the costs involved in a loan in terms of percentages. A $100 loan with a 10 percent APR will charge you $10 per year. Obviously, since that scenario doesn’t involve paying off any principle, it’s not exactly the best example, but you get the idea.

The limitation of APR

Unfortunately, there are limitations. Your APR may include more than just the interest on the loan. It might include things like processing fees or even mortgage insurance on a home loan. You need to look at the APR in detail so you know what is and what is not figured in for any given loan. You need to know what charges and expenses are involved in a loan. Beyond that, you need to get the big picture and look at how long you’ll have the loan to decide whether or not it’s worth it.

Calculating APR

If you need help figuring out the APR on a potential loan, ask the lender. They are required by federal law to provide you with the APR on a loan. If you want to calculate it on your own, there are a number of online services that can help you do exactly that, as well.

Photo via English106

Recently, Ernst & Young set out on a national study to determine whether the pricing of payday loans was fair and reasonable. The findings of the study may be surprising to some, and suggest that the issue of payday loans isn’t as cut and dried as opponents would like for you to think it is.

The study found, among other things, that attempts by state legislatures or other governmental entities to create and impose an artificial cap on the rate for payday loans would have a detrimental effect. It would, in effect, eliminate a product that millions of Americans use to address short-term credit needs.

In addition, the study found that, on average, payday advance lenders charge just over $15 for each $100 lent to consumers. The average cost to the payday loan store was just under $14 for every hundred dollars loaned, meaning that their profit margin isn’t outside normal standards for retail or financial businesses. The average profit margin was 9.1 percent before taxes.

Lenders in the payday loan industry face far greater risk than those lenders who offer more traditional loans that require a form of collateral. Around 27 percent of the cost of each loan went toward bad debt.

Reducing the fees that payday loan lenders charge, then, would greatly impact the ability of these businesses to function. The vast majority of the more than 10,000 payday lenders around the nation operate within the percentages for profit margins outlined above, and would not be able to keep their doors open if rate caps were put in place.

A typical payday loan last for two weeks at a cost of $15.26 per $100 borrowed. This works out to an annual percentage rate of 397 percent. That rate sounds astronomical, and would certainly be if the loan were for a term of one year. The very idea of an “annual” percentage rate for a short-term product like this is, at best, misleading.

Incidentally, some of the proposals in state and federal legislatures would cap the APR at 36%. According to the Ernst & Young study, this kind of a cap would make payday loans unprofitable. This would force the lender to stop offering the product.