The 400 Percent Loan, the $36,000 Hotel Room, and the Unicorn
Why the Annual Percentage Rate is a Poor Tool for Measuring Short-Term Credit
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Is a $16 surcharge on a $100 product unfair, unjust, and “predatory”? Hardly anyone flinches, for instance, at a $16 “resort fee” on a $100 hotel room. But when it comes to short-term loans offered by non-bank institutions, mostly payday loans, politicians call for banning the practice, using dubious arguments about such loans’ true cost.
Before he was installed in a controversial “recess” appointment in January, the White House issued a report urging the confirmation of former Ohio Attorney General Richard Cordray as director of the new Consumer Financial Protection Bureau (CFPB), “because some studies have found that payday lenders on average charge fees of roughly $16 for a two-week loan … this translates into an annual percentage rate of roughly 400 percent.”
How does that work? Quite simply, it does not. The Obama administration and other politicians who make this argument are using a flawed method of calculating interest that is an apples-and-oranges application of annual percentage rate (APR) to loans of a much shorter duration than one year.
A typical payday loan in the U.S. covers a period of two weeks, tracking the interval of time between paychecks. Interest and fees3 come to $10 to $20 per $100 of the amount of the loan, the total amount of which is usually $500 or less. Such loans are often taken out during emergencies to pay immediate costs that can be covered with the arrival of the next paycheck.
Were a borrower to take out a new loan every two weeks for a year, the total would indeed equal 420 percent. The only problem with that scenario is that it does not match reality. State government data on payday loans show that hundreds of thousands of borrowers take out just one loan per year and pay back the loan within the two-week duration. Even staunch critics of payday loans have yet to name a single individual who has paid close to 400 percent over a year from a law-abiding lender.
The 400-percent interest rate is the financial equivalent of a unicorn, yet it has driven public policy regarding short-term credit with destructive results for the neediest of borrowers.