Payday loans and high cost credit

A payday loan is a single payment loan. The borrower takes an amount now, signs a post-dated cheque or authorises a debit for the next payday, and repays the whole amount plus one fee on that date. Nothing amortises: there is no meter running, no schedule of instalments and no balance that falls as payments are made, because there is only one payment.

The fee is usually quoted per hundred dollars borrowed. At $15 per $100, a $100 advance is repaid as $115 in 14 days. That is 15 percent of the amount borrowed, charged once, and under this pricing it does not shrink if the money is repaid early. It is an unsecured loan in that no property is pledged, but the lender holds an instrument that reaches the borrower's bank account on payday, which is a different kind of security from a claim in court.

High cost credit covers a family of products built the same way, differing mainly in what backs them.

Those pricing conventions are local rather than inherent. Some regulators require a short term loan to carry daily interest with a rebate for early repayment instead of a flat fee, and some require an overdraft to be quoted as a rate rather than as a charge per item. What the family shares is a fixed charge over a short term. That combination is what the next section turns into a rate.

An APR restates a charge as a yearly rate so that products with different terms can be compared in one unit. Two steps do the whole job: express the fee as a share of the amount borrowed, then multiply by the number of times that term fits into a year.

$$\text{APR} = \frac{\text{fee}}{\text{amount borrowed}} \times \frac{365}{\text{days in the term}}$$

For a fee of 15 percent on a 14 day term, $0.15 \times \frac{365}{14} = 3.9107$, which is about 391 percent. Counted in whole fortnights instead, a 364 day year holds 26 of them and the same sum gives 390 percent. The gap between the two figures is the single day a 365 day year has beyond 26 whole fortnights, not a disagreement about method.

The term is doing as much work as the fee. Every figure below is an APR in percent, for the same fee applied over three different term lengths:

Halving the term doubles the APR while the amount of money changing hands does not move at all. That is the property worth holding on to: an annualised rate is a comparison unit, not a forecast. It answers the question a borrower comparing this against a card or an instalment loan has to ask, and it deliberately does not describe what one 14 day loan costs, which is the fee and nothing else.

Renewal is the point where the annualised rate stops being hypothetical. A payday loan takes the whole amount borrowed plus the fee out of one payday. If that money was already committed to rent, food and bills, clearing the loan reopens the same shortfall it was taken out to cover, and the cheapest looking move on the day is to pay another fee and push the due date to the next payday.

The fee repeats and the amount borrowed does not fall. A loan carried through eight terms at 15 percent a term, which is the original plus seven renewals, costs 120 percent of the amount borrowed in fees, and the principal at the end is exactly what it was at the start: on a $300 loan, $360 handed over with $300 still owed. An instalment loan runs the other way, because every payment reduces the balance and so reduces what the next period can charge, which is what amortisation means.

Where renewals are capped or banned, a pattern that commonly appears instead is repayment followed by a fresh loan days later, since a rule about paperwork does not by itself close the shortfall, and supervisors who publish figures on this tend to count the run as one loan sequence and measure it that way. Whether restricting the product leaves borrowers better off is a further question and an unsettled one: it turns on what they substitute into, which differs by place, and the published studies point in both directions.

Compounding only enters if a fee goes unpaid and is added to the balance, because the next fee is then charged on the fee as well. That is compound interest running against the borrower, and over a full year at 15 percent a fortnight it is the difference between 390 percent and 3,685.68 percent. The APR against APY calculator above turns any periodic charge into both figures.

Three things are true at once here, and dropping any of them produces a bad decision.

The APR is calculated correctly. It is also the unit that lets a two week fee and a card rate be set beside each other at all, so a borrower who ignores it is comparing nothing.

The APR is not a prediction. Borrow $300 for one 14 day term at 15 percent and the cost is $45. It reaches 390 percent of the amount borrowed only if the fee is paid in cash and the term renewed through all 26 fortnights of a year, which is a decision taken 25 further times rather than anything in the original contract. Left unpaid and rolled into the balance instead, the same pricing produces 3,685.68 percent, so a loan still outstanding a year later carries two very different totals depending on whether its fees were paid or added.

A large annualised number also identifies a short term, not only an expensive lender. Run the same sum on a flat overdraft fee for a small shortfall covered three days later and the APR lands in the thousands of percent. Late fees and returned payment fees behave the same way. Part of this is structural: originating, funding and collecting a small loan carries a cost per loan that barely changes with the size of the loan, so any price covering it is a large percentage of a small amount held for a short time.

None of that makes the fee small. It means the figures to act on are the total number of dollars repaid, the date they are due, and whether that date can be met without borrowing again. The APR ranks the offers; the dollar cost and the due date are what a borrower lives with. A borrower already carrying several fixed commitments can see the second question directly in a debt-to-income calculation.

The honest comparison is between the options actually open to a particular borrower, not between a payday fee and a rate nobody offers them. Access is the binding constraint most of the time, which is why a thin or damaged credit file matters here more than a price list does. How credit scores work explains what a lender is reading.

With that said, the same $300 priced three ways:

• A payday loan at 15 percent a term. $45 per fortnight, repeating for as long as the loan is renewed, with the $300 untouched.
• A small instalment loan at 36 percent a year, the level United States consumer lending rules most often use as a benchmark ceiling, repaid over six months: $55.38 a month and $32.28 of interest in total.
• A credit card charging 24 percent on purchases, paid down at $45 a month: clear in 8 months for $25.26 of interest. The same $45 that buys one two week extension clears the whole balance in under a year.

That last row prices a balance already sitting on the card, which is not the same thing as pulling cash out of it. A cash advance is a separate product from a purchase: it usually carries a fee, a higher rate and no grace period, so interest starts on the day the money is taken. A card used the way a payday loan is used therefore costs more than the row above, not the same.

Options that do not involve borrowing are worth pricing too, because some carry no charge at all. Utilities, medical providers and landlords often run payment plans or hardship deferrals. Some employers advance wages already worked for at no charge. A pawn loan is expensive but caps the downside at losing the item, because it is normally non-recourse: default costs the pledged item and nothing beyond it. And the one arrangement that removes the need rather than repricing it is cash set aside before the shortfall arrives, which is what emergency funds are for.

Regulation of high cost credit is jurisdictional, and quoting any particular ceiling as a fixed fact dates fast. The levers themselves are stable, so those are worth knowing.

• A price cap, written either as a maximum fee per amount borrowed or as an APR ceiling that includes fees.
• A renewal limit, capping how many times one loan can be extended.
• A cooling off period, forcing a gap between paying one loan off and taking the next.
• An affordability test, requiring the lender to check that the borrower can repay and still cover ordinary expenses.
• Licensing and a statewide or national database, which is what makes the limits above enforceable across lenders.

In the United States, payday lending is licensed and capped state by state, so the same loan is legal in one state, differently priced in the next and unavailable in a third. Federal law adds a separate ceiling for active duty service members and their dependants, expressed as an all-in annual rate that counts fees rather than interest alone. Where a cap binds, lending often reappears in a longer instalment form priced up to it, so the product name is a weaker guide than the arithmetic.

On any specific offer, five questions settle most of it. What is the total number of dollars repaid, and on what date? Does the loan renew automatically if the debit fails? What does a failed debit cost, at the lender and at the bank, and how many attempts are allowed? Is the lender licensed where you live? And is on-time repayment reported to the credit bureaus that mainstream lenders where you live actually read, since high cost lenders commonly report a default while reporting nothing at all when the loan is paid on time, so repaying does not necessarily buy access to anything cheaper later.