The true cost of payday loans is one of the ticklish issues and critics of this type of short term loan cite the “exorbitant” APR off the bat to justify their position. The implication of arguments anchored on this annualised metrics is that payday lending companies are enjoying a windfall from such loans with high interest rates at the expense of those who are in dire need of cash.
When determining the actual cost of payday loans, it is worth noting that it is quite misleading to use APR within the range of actual cost comparison of payday loans with traditional and other forms of short term loans. We have to remember that payday loans are unique as such bridge financing are made for a shorter period of time compared to the other types of loans. And while APRs of payday loans are well within the 3-digit range, these ‘sky-high’ rates have limited bearing on the actual cost of the payday loans.
Taking a Short Term Perspective
The principle behind this process can be compared to a hypothetical example where a taxi quotes a price of £15,000 for every 1,000 miles travelled or a hefty sum of £50,000 for a ton of tuna. Of course, we are well aware that no sane person will actually choose to travel a distance of 1,000 miles in a taxi or buy that many tuna. Taxis are specifically intended for short distance travelling and you will only buy a few pounds of tuna. In the same breath, you only use payday loans to address short term cash flow problems and this would normally last for a month.
It is also important to point out the fact that banks and other lending entities compete for a bigger share of the market and offer premium rates to get ahead of competition. In addition to this, we must remember that payday loans are relatively more expensive than traditional loans but can actually be the cheaper alternative in absolute terms.
A short term perspective is especially important should you be out of work and looking for loans on benefits because your income is restricted and you don’t want to get any late payment penalties which may send you repayments spiralling upward.
Breaking Down the Cost of Payday Loans
The fees levied on payday loans are used to cover the cost associated with the processing and verification of loan applications, capital cost and overhead expense. The key difference is that such cost is spread over a larger business portfolio for companies that specialise in larger loan packages, while payday lending companies draw such operating funds from their margin on loans with smaller amounts. This explains why banks and other entities that provide traditional loans charge lower annual interest than a number of payday lending companies.
Payday lending companies also have greater risk than banks and other companies that specialise in traditional loans. In most cases, short term loans have higher default rates and this means an escalation in the risk premium of such loans, which ultimately increases the cost of such loans. Thus, we have a situation where the interest rates of payday loans and such other types of short term loans are inevitably higher. Providers of short term loans are forced to find a way to recoup their investment and maintain a fair margin for the service they provide to remain viable.
Because of its expensive nature, payday loans and other forms of short term loans should never be tapped as a main financial option. It is a short term cash solution and the decision on whether one gets a payday loan or not should be made by weighing the flexibility of having a reliable source of instant cash against the cost of such loan. You must always decide on the cost or foregone benefits that you may incur in the event you decide against getting a payday loan for a short period of time.