Payday loan APR explained (original) (raw)

Payday loans are one of the most expensive ways to borrow, so if you’re planning to get one, it’s important to compare lenders. While this type of borrowing is meant to tide you over for a short time, choosing the wrong loan could just create more financial strain.

But, frustratingly, choosing a loan isn’t always as straightforward as just scanning through annual percentage rates (APRs) to see which is lowest – with the apparent “lowest” rate not always the best deal.

Warning: Late repayment can cause you serious money problems. For help, go to moneyhelper.org.uk.

Please note: High-cost short-term credit is unsuitable for sustained borrowing over long periods and would be expensive as a means of longer-term borrowing.

What is APR?

The annual percentage rate (APR) is designed to provide a summary of the annual cost of borrowing, taking into account the interest and any mandatory charges. All companies issuing loans or other credit based products like credit cards, mortgages and overdrafts have to calculate the APR for their product in the same way. The watchdog – the Financial Conduct Authority (FCA) – says that lenders must tell you the APR before you sign a loan agreement.

How does it apply to payday loans?

First off, it’s crucial to appreciate that these loans are eye wateringly expensive, no matter how much lenders try to justify their rates. That said, the APR can be misleading when used in relation to payday loans, for the following reasons.

• Payday loans are very short term products, traditionally covering terms of up to a month. Many payday lenders now let borrowers spread repayment over a few months, but these loans are still typically much shorter than a year. So talking about, say, a 30 day loan in terms of an annual rate can make very high interest rates (like 292%) sound sky high when expressed as an APR (more than 1,000%). If you were to borrow £50 from a friend, and buy them a pint a week later to say “thanks”, that would translate into a similarly enormous APR.
• Payday loans charge simple interest, not compound interest. The formula that lenders must use to calculate the APR of loans is really based on loans that charge compound interest – that’s where you pay interest on interest.
• Many lenders charge different rates of interest depending on how much you want to borrow, and how long you want to borrow it for. However they may only display a single representative APR figure on their site, summarising the full range of loans they offer. This goes for some payday loan comparison sites too, where you may see loans with similar projected costs but wildly different APRs.
• The rate you’re offered can depend on your particular circumstances. Lenders are only obliged to award the representative APR to 51% of borrowers (that’s one of the reasons why it’s referred to as “representative”) – if they think you’re particularly high risk, they might offer you a higher rate. In reality, the FCA has capped payday loan interest at 0.8% per day, and many lenders pitch their rates right on, or just below, this threshold.

So how should I compare lenders?

If you can’t trust the APR, what do you do? Fortunately the answer is actually quite simple.

When comparing lenders, you should first consider how much money you really need to borrow. Once you know how much you need, compare different lenders by focusing on the overall cost, also sometimes referred to as the “total payable”. Aim to keep this figure as low as possible, while ensuring you can comfortably afford the repayment schedule.

The repayment period you opt for will normally depend on the affordability of repayments. While you’ll want to pay off your loan as soon as possible, make sure the repayments are realistic for your budget so you don’t end up with further financial pressure. Many lenders charge late payment fees of up to £15, which could dramatically increase your overall bill.

We compare payday/short term loans from

Dos and don’ts for comparing payday loans

Do:

• Explore your other options, such as a credit builder credit card or borrowing from a friend or family member. These could be significantly less costly in the long run. Applying for a payday loan should be a last resort.
• Concentrate on the overall cost when comparing loans. The lowest APR offered might not be the best deal for you.
• Remember that as a general rule of thumb, the longer the repayment plan, the more the loan will cost you overall. A loan with a better rate is one thing, but if it means borrowing over a much longer term than you had planned, this could be a false economy. However…
• Check the early repayment terms of any loans you’re considering. If a longer loan has a better rate, but you can repay it early and only pay interest on the days on which you were borrowing, taking out that loan could work out cheaper overall for you.

Don’t:

• Apply for a loan if you can’t afford the monthly repayments. Be realistic about your budget.
• Apply for the loan with the lowest APR, without considering the overall cost.
• Submit multiple applications in a short space of time – this could impact negatively on your credit score and put off lenders.
• Take out a payday loan for a non essential expense.
• Use payday or short term instalment loans often, or over longer periods.

Bottom line

When comparing short term loans, the APR can be pretty useless, and shouldn’t be your guiding factor when looking for the best deal. Focus on the total repayment amount to guide your decision, which can vary depending on the loan amount, the size and frequency of the repayments, and your credit history.

A payday loan should always be considered your last option when you’ve explored all other alternatives. It remains one of the most expensive ways to borrow, despite an FCA crackdown a few years ago.

If you do decide to apply, make sure the repayment plan and costs are realistic to your financial status.

Frequently asked questions

We show offers we can track - that's not every product on the market...yet. Unless we've said otherwise, products are in no particular order. The terms "best", "top", "cheap" (and variations of these) aren't ratings, though we always explain what's great about a product when we highlight it. This is subject to our terms of use. When you make major financial decisions, consider getting independent financial advice. Always consider your own circumstances when you compare products so you get what's right for you. Most of the data in Finder's comparison tables has the source: Moneyfacts Group PLC. In other cases, Finder has sourced data directly from providers.

Chris Lilly is Head of publishing at finder.com. He's a specialist in personal finance, from day-to-day banking to investing to borrowing, and is passionate about helping UK consumers make informed decisions about their money. In his spare time Chris likes forcing his kids to exercise more. See full bio

Chris's expertise

Chris has written 617 Finder guides across topics including:

• Loans & credit cards
• Building credit
• Financial health

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