SEP 11, 2011 3:10 PM

# What is APR And Why Is It So High For Payday Loans?

APR is short for Annual Percentage Rates and it is the figure the Office of Fair Trading insist all loan companies prominently display to show customers how much interest it is calculated they would pay per year assuming compound interest is charged.

The problem with APR calculations when it comes to short term lending such as payday or logbook loans is that the figure is misleading because the loans are never for more than a month or two. This is why you see APR shown as 4 figures when looking at payday loans even though you would never pay that amount.

Lets look at an example:

You take a payday loan out for £100 with QuickQuid for 30 days for which they charge you £20. At the end of the 30 days you pay them a total of £120, the debt is settled and you have paid them 20% in interest.

Now lets say you can’t pay it back at the end of the month and so extend the loan for a further 30 days. When you settle the debt at the end of the second month your payday lender will charge you £40 interest – £20 for each month so you have to repay a total of £140

Compound Interest Explained

Before we go further we now need to understand how compound interest works. The payday lender above has not charged compound interest, they have charged a straight 20% per month for the loan.

If compound interest were used in the above example the second months interest would be worked out thus: 20% of £120 (the original £100 you borrowed plus the £20 interest accumulated for the first month) making the interest charges for the second month £24 so you would now owe £144

This makes the loan £4 dearer when using compound interest which doesn’t seem much but do that 12 times to represent a full year and it soon adds up. The next month would be 20% of £144 and so on.

OK, back to our example. QuickQuid show they have an APR of 1734% but APR is a figure that shows the annual interest you would pay after a year when the interest is compounded as it is with mortgages and other long term loans even though QuickQuid do not use compound interest or lend money long term.

As you can imagine, knowing and understanding the APR of a long term loan or mortgage would be a major help when looking for a lender. Because payday loans are usually for no longer than a month though the figures don’t really represent anything other than the answer to a couple of ‘what if’ questions. What if I had the loan for 12 months and what if the payday lender used compound interest?

Now having said all that, looking at the APR on a payday loan web site or TV ad will indicate to you whether it is a cheap or expensive lender even though you will never pay those rates and so we would advise you use the APR figure as arough guide when looking for a suitable payday lender, pawnbroker or other form of short term instant cash loan.

For example the Wonga APR is 4214% whilst the Payday Bank APR is just 1727% so you would be correct in assuming Payday Bank is going to charge you a lot less than Wonga will charge you in interest for a 1 month payday loan.

However, because APR assumes compound interest accumulated over a year, Payday Bank won’t be half the cost of Wonga despite the APR being half as much (actual figures are £36.72 per £100 borrowed with Wonga and £25 per £100 borrowed from Payday Bank).

The best way to work out how much a short term loan will cost you is to find out how much you will be paying back per month for each £100 you borrow. We have done this for you to make it easy to compare payday loans by seeing the figures from all the major lenders side by side. You can see our comparison chart by clicking here.