Budgeting Loans

How Is the Interest Rate on a Payday Loan Calculated?

As of 2021, the average payday loan is about $375. With loan amounts this low, you would think that interest rates on a pay day loan online would be pretty reasonable. Unfortunately, this is not the case. So, how are the interest rates on a payday loan calculated? 

How Does Interest Work on a Payday Loan?

How do interest rates on payday loans work? Payday loan interest rates are known for being extremely high. When you sign a contract, a certain percentage of the principal balance is used to calculate interest. That means, generally, the higher your loan amount, the more money you will pay in interest on a payday loan. 

Interest rates with payday loans are often high even when borrowers pay back their loan within the given loan terms. But, interest rates get even worse for people who take longer to pay back their payday lenders. Loan terms on a payday loan are usually about two weeks or 14 days. Borrowers who fail to pay back payday loans within this very short period are usually stuck with extremely high rates that may actually cause their balance due to increase from month to month. 

How To Calculate Interest on Funding From Payday Loan Lenders

Let’s take an example of a payday loan and break down how to calculate the interest rates. Say you had a $200 payday loan with a repayment schedule lasting two weeks. If the loan carried a $30 fee, then the APR would be around 400%. 

How did we determine that 400% interest rate? Let’s break it down. 30 is 15% of 200. To find the annual percentage rate of the loan, we must then multiply that 15% by the number of days in one year, 365. 

Mathematically, that would look like this: .15(365) = 54.75.

Next, you would divide the answer by the length of the loan term, which in this example is two weeks or 14 days. Mathematically, that would look like this: 54.74/14=3.910. 

The last step is to simply move the decimal point over two places to the right to get the APR. So, a $30 charge on a two-week payday loan of $200 would result in an annual percentage rate of 391%.  

What Are the Different Types of Interest?

There are several different types of interest lenders can charge on a loan. Before you sign a loan agreement and commit to any one loan, it is best to be familiar with the interest rates and how they work. Some types of interest you may come across on a loan are: 

APR

The annual percentage rate, also known as the APR of a loan, refers to the amount of interest paid over the course of one year. The APR of a loan is typically broken down and applied to each monthly installment, so borrowers pay interest while they are paying back their principal balance. 

Fixed Interest

Fixed interest is when the rate of a loan does not change. Since the rates never change, monthly payments will also be consistent throughout the loan term. Fixed interest rates can make budgeting for a loan extremely convenient since you don’t have to worry about payments potentially being higher or lower each month. 

Variable Interest

Variable interest means that the rate of the loan can change from month to month. Variable rates are determined by current market conditions, which means you may pay more for some months and save money for others. Depending on the market, loans with variable rates may be a great way to save money on a loan for people who can handle a bit of financial fluctuation in their payments. 

Simple Interest

When a loan has simple interest, it means the rates are calculated using just the principal balance. Since it is so straightforward, many types of loans use simple interest. Some examples of loans that use simple interest are most: 

  • Personal installment loans. 
  • Bad credit installment loans. 
  • Personal loans from a direct lender. 

Compound Interest

When a loan has compound interest, it means that rates are calculated using both the principal amount in addition to interest charges on past payments. Since the interest accumulates, or compounds, loans with compound interest can get expensive quickly. 

What Is the Most Common Type of Interest Charged by Payday Lenders?

Most payday loan lenders use simple interest when determining rates. However, it is important that payday loan borrowers do everything in their power to pay off their loans within their given loan terms. If not, the interest charges may actually cause the overall balance to increase from month to month. 

What Happens if You Don’t Pay Back a Payday Lender?

What happens when payday lending goes wrong, and you are no longer able to keep up with your monthly payments? One missed payment on a payday loan isn’t the end of the world, but it might bring your credit score down a bit. Multiple missed payments may eventually lead to loan default, which will hurt your score in a much more significant way. Loan default may leave a negative mark on your credit score for up to seven years and hinder your ability to apply for other loans in the future. 

Furthermore, while payday lenders legally cannot threaten you with jail time, they may be entitled to wage garnishment if you don’t repay payday loans. Wage garnishment is when a lender takes money directly out of a borrower’s bank account. 

If you have a payday loan online and are struggling to keep up with your payments, reach out to your lender and see what they can do for you right away. 

Loans With Better Interest Rates Than Payday Loans  

Thankfully, there are much better loan options out there besides payday loans. Check out the financial products below to learn about funding that can come with better interest rates over payday loans! 

Bank Loans

For traditional loans, you can go to a bank. However, banks usually only accept applicants with credit scores in good standing. So, if you have a credit score on the lower side, or if you have dealt with financial inconveniences like bankruptcy, you may not want to go to a bank for a loan. 

Personal Installment Loans 

One of the most versatile types of funding is a personal loan, also called a personal installment loan from a direct lender. With personal loans, borrowers are paired with competitive interest rates and personalized payback terms. Furthermore, personal loans are available to borrowers with either high or low credit scores. This availability is why personal installment loans are often referred to as bad credit installment loans. 

Credit Union Loans 

You may also get a loan from a credit union. Credit unions are a special type of financial institution owned by borrowers instead of investors. Since the owners of credit unions are not necessarily seeking a profit, they often offer unique borrowing perks you may not be able to find anywhere else. 

Something important to note about credit unions is their approval requirements can be quite strict. Many credit unions require their borrowers to live within a certain area, work in a particular field, or have a credit score within a certain range in order to qualify for a loan. 

How Do I Save Money on Interest Rates?

Looking to save money on interest rates on your next loan? Try the tips below! 

Work on Your Credit 

One of the most efficient ways to get paired with ideal interest rates is to work on your credit score. Often, your credit reports and credit score are the first things lenders look at when determining loan approval, terms, and rates. Borrowers with higher scores are paired with lower rates typically. 

If you have been working on your credit and already have a loan, you may consider refinancing that loan in order to get better loan terms or interest rates!  

Pay Extra on Your Loan Payments 

Try to pay more than the minimum amount due on your loans each month. The quicker you chip away at your overall loan balance, the less interest you will pay over the life of your loan! In addition to making larger payments, you may also make additional payments each month on your loan. Try to make a habit of putting whatever extra money you have lying around towards paying off any loan balances you have. 

The Bottom Line: Interest Rates on Payday Loans 

After working with payday loans, many borrowers think of them as predatory loans or a debt trap. Beware of the predatory lending techniques used by most payday lenders, so you don’t get sucked into a loan deal you end up regretting. Fortunately, there are plenty of other great options available to help you take care of your financial obligations! 

References:
How Payday Loans Work: Interest Rates, Fees and Costs
What are Interest Rates & How Does Interest Work? | credit.org