It’s that big scary percentage which does it. When you think “payday loans” so many of us immediately flash to that great big, four digit number which can (surely) only mean one thing – overpriced loans. 4800%, 5000%, 6600%; the APRs which now have to be displayed prominently by all short term lenders look, admittedly, pretty terrifying (Wonga’s website displays a representative 5853% APR figure, alternative providers can range up to 7069%). These scarily large numbers make for good headlines and simple sensationalism. This must be at least part of the reason why payday lenders get the stick they do from the media. It’s easy to hold up these figures and cast short term lenders as ruthless money grabbers.
The reality of APR
But, when you look a little closer at what APR actually means, you’re in for a surprise. And the clue is in the acronym: APR – Annualised Percentage Rates. While short term loan terms rarely exceed five weeks and often last no longer than a matter of days, APR is calculated on an annual basis. This means that the big scary percentage doesn’t really mean much in real terms to the cost of your short term loan. In fact, the shorter your loan period, the less relevant APR gets. When it comes to ways to calculate the cost of a payday loan, APR may be mathematically correct but it’s an unsuitable gauge which can be misleading if swallowed whole.
A better gauge
If you want a more suitable, telling figure to gauge the cost of a short term loan, you can dispense with APR altogether. The big scary number may be branded across short term lender websites and materials, but the numbers you really need to care about are the actual interest rate and, most importantly, the total cost of credit. If you’re looking at a number of different loans, this is a much better way to run a fair comparison which makes sense to you and your wallet.
APR – no longer relevant?
Using APR as a basis for your short term loan decision will soon make even less sense. The FCA (Financial Conduct Authority) have now taken over payday loan regulation and have brought with them a raft of new legislation.
In July 2014, the FCA implemented a number of new rules. All TV advertising for short term finance must be accompanied by a “risk warning” which displays contact information for debt charities. More importantly, loans can no longer be rolled over more than twice. This means that the time frame in which loans can accrue interest and charges is seriously limited. With time periods effectively capped, APR simply doesn’t make sense to this type of financial product.
Even more significantly, from January 2015, all payday loans will be capped. The FCA will apply a 0.8% per day cap on interest to all payday loans. This means that no loan can ever exceed the initial borrowed amount in charges and interest. The regulatory body also plan to implement a cap on extra charges, this limit is expected to be around £15.
With all of these regulatory changes ahead, APR looks even less relevant than ever before. The 0.8% will lower APRs across the board, but with limited rollovers and capping of interest, there’s simply no way that short term loans can be extended to an annual period and accrue the kind of percentage an APR reflects. And with non-interest related charges in the mix which vary from provider to provider – you’re better off focussing on other points of comparison.
Get a financial education
With so many confusing and misleading figures floating about, it can be difficult for consumers to really get to the crux of what they’ll be borrowing and how much it’s going to really cost them. Instead of focussing on APRs, it’s much more helpful to take some time to really understand the product you plan to use. Get to know your lender and ask them to outline the real interest and all of the charges which could affect how much you will ultimately need to pay back.
Do you think that forcing loan providers to display APRs is helpful or misleading? Would you like to see a different measure like actual interest rate used instead? How can providers help to educate potential customers about the product they’re considering? Share your thoughts and experiences with readers below.
Thomas Goodall is a money man and blogger extraordinaire, keeping tabs on financial newsflashes and money matters. He writes for the web and occasionally makes forays into print.