Monthly interest calculator: the payday loan trap
Payday loans with high interest rates are advertised as a stopgap until your next payday. But what if you can't pay them back?
BBC Three documentary Young, British and Broke: The Truth about Payday Loans shows the stories of several young people who 'refinanced' payday loans - took out a new loan with another company to pay off the first loan, including any interest owed.
The risk of this is that you are paying interest on a bigger and bigger balance each month.
If you refinance like this several times, the 'compounding' effect of the high interest rate can quickly spiral out of control. You can see how with this monthly interest calculator.
On any borrowing, the two key things that affect the interest cost are the annual percentage rate of interest (APR) and how long you borrow for.
Drag the bar below to set the APR. Payday loans are typically 1000% to 6000% APR.
Then hit PLAY to see how the interest would go up if you kept refinancing each month. To compare the interest for two different loans, hit COMPARE.
1. What is APR?
Payday loans: check the costs
- Advertised monthly costs may seem low, but annual rates are significant
- Loans are quick but customer service can be poor. The Financial Ombudsman receives more than 50 complaints about payday lenders every month
- Other lenders like banks or credit unions may offer a better deal. Here are ten things to check before you take out a loan
APR stands for Annual Percentage Rate.
The annual percentage rate on a loan is the amount the lender would charge if you borrowed the money for a year, as a percentage of the original loan.
For instance at 40% APR, to borrow for a year you'd be charged 40% of the original loan, on top of paying it back.
So if you borrowed £100 at 40% APR for a year, you'd have to pay back the loan plus £40.
The APR is sometimes referred to as the 'interest rate'. However it also includes any other charges and administration fees, except where they are avoidable, such as late repayment fees.
2. Why an annual rate? I'm only borrowing for a month or two.
When lenders advertise loans, they must show the APR by law. People borrow money for different lengths of time, so the annual percentage rate gives a standard way of comparing loan costs.
It doesn't mean the lender will actually lend you money for a year, but it's the standard for comparing deals. If you pay back your loan in less than a year, you'll pay less than the annual rate in interest.
3. I'm not a maths whizz, how can I understand APR?
- Per cent just means per hundred. So for money 1% is 1p in the pound. 50% is 50p in the pound.
- A loan at 10% interest per year charges 10p for every pound borrowed every year
A simple way of thinking of APR is how many pence it would cost you to borrow each pound, per year.
So for instance at 40% APR, on each pound borrowed you would pay 40p a year.
At 400% APR, on each pound borrowed you would pay 400p or £4 a year. At 4000% APR, you would pay 4000p a year, that's £40 on each pound borrowed.
4. Percentages are out of a 100 aren't they? How can an APR be over 100%, like 4670%?
An APR of over 100% just means that if you were to borrow for a year you would be charged more than 100% of the original loan. So for each pound borrowed, you'd pay more than 100p.
For APRs over 100% a quick and easy way to read them is to imagine a point in front of the last two figures.
For instance 4670% APR becomes £46.70. This is the amount you would pay on each pound borrowed, per year.
See the box and link on the right for more information about percentages.
5. The monthly percentage interest rate looks much lower. Is the APR just the monthly rate times 12?
No. As well as the APR which they must show, some lenders advertise a monthly percentage interest rate, which looks much smaller.
However beware, the APR is more than the monthly rate times 12. The APR is worked out on the basis that you refinance each month for 12 months.
When you take out a new loan to pay off the first one - plus any interest - the next month's interest payment is likely to be significantly MORE. That's because you'll be paying interest on the new bigger balance after a month, which includes the original loan as well as the interest you have built up.
And if you couldn't afford it after the first month, will you be able to afford even more the second month?
If you repeated this compounding over 12 months by refinancing each month, all the interest you paid each month added up is equivalent to the APR. This may be over a hundred times the first month's interest rate.
The higher the monthly rate, the faster the overall cost of the loan soars which is why it's important to get the lowest rate. For instance credit unions are capped at 2% a month, which is just under 27% APR, or 27p interest per year on each pound borrowed.
6. What's the difference between payday loans and instalment loans?
Payday loans are short-term, high-APR loans, usually designed to be paid off completely at your next payday. Instalment loans, for instance from banks or credit unions, are longer-term, lower-APR loans, which you pay off in regular arranged instalments to spread the cost.
Some payday loan companies offer to let you 'roll over', paying just the interest for a small number of months to postpone paying back the original loan. However at high APRs this monthly interest alone can quickly add up to more than the total originally borrowed.
If you need credit longer term it is worth looking into arranging lower-APR instalment loans, for instance from a local credit union.
7. Why are the APRs on loans from credit unions so much lower?
Payday loan adverts often emphasise how fast you can receive a loan. But this may mean you rush into borrowing money at very high interest rates.
Lenders such as credit unions or banks may take a day or two to process your loan request and check it's affordable. But they usually have much cheaper rates, for credit unions capped by law at just below 27% APR, which could save you a lot of money on interest in the long run. And because credit unions are not-for-profit they may be more sympathetic to your personal financial situation.
To compare the interest cost of different types of credit over one month, try setting the APR on the tool above then sliding the time period to 1 month.
8. The advertised APR is the one they must charge me, right?
No. The APR lenders show on their adverts is NOT necessarily the rate you personally will be charged. It may be just a "representative" rate.
In practice lenders often charge different people quite different APRs depending on various factors including the amount borrowed and duration of the loan - so you may actually be charged more than the rate in the advert.
9. What about other fees charged on top of interest?
Some lenders add various extra fees and charges on top of the interest, especially for late repayment. And not all of these are factored into the APR.
Sometimes people only realise too late that they haven't read the small print.
Remember to compare lenders' charges as well as their APRs and make sure you fully understand all the charges before you commit to borrowing. Especially what will happen if you don't repay on time.
Take your time to look at the small print and don't be afraid to keep asking until they have explained it all clearly, or to walk away. Remember you are the one who is paying them for the loan - it is the lender's responsibility to make it clear what you are signing up to!
10. TOP TIP
Remember to think carefully about the cost of any loan, including the interest rate and any charges, and how and when you will get the money to pay it back.
If you can possibly plan to save some money at the same time, you can start earning compound interest instead of paying it.
Young, British and Broke: The Truth about Payday Loans was broadcast on BBC Three on 3 December 2013 at 21:00.
The tool on this page offers a simplified calculation of how costs can spiral if you keep taking out short-term loans. The costs for different companies will vary and there may be additional fees and charges. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.