If you have only ever heard one thing about short-term loans – sometimes also known as payday loans – it’s probably that the interest rates charged are astronomically high in comparison with other types of loan. It’s a narrative that is repeated a lot, but one that is more misleading than you might think.
The biggest problem is that short-term lenders are required to display and disclose the APR attached to any loan they make. And yes, 1261% APR sounds very high. However, when you are talking about a small short-term loan the APR simply isn’t a good indicator of value at all.
What is APR?
Basically the APR – Annual Percentage Rate – is a number that describes the cost of a loan in annual terms. It is rather different to an interest rate.
An interest rate refers only to the interest charged on a loan, and it does not take any other expenses into account. In contrast, APR is the combination of the nominal interest rate and any other costs or fees involved in procuring the loan. As a result, an APR tends to be higher than a loan’s nominal interest rate.
Knowing the APR, especially on a large loan like a mortgage, can be very helpful. In the case of a small short-term loan it can also be rather misleading for the following reasons:
APR and Loan Size
From a lender’s point of view, the additional costs of providing a small loan are the same as those of providing a larger one. A smaller short-term lender still needs the same equipment and staff to process a loan as a larger bank does. However, a longer loan term means that a lender can actually recover more of their costs, but in a less visible way.
This means that the APR on a larger, long-term loan appears to be lower than that on a short-term loan. But in reality, 10% of a £200 loan is £20, whereas 10% of a £20,000 loan is £2,000. Who earns more? Exactly, but the two lenders are judged in the same way when you base everything on APR.
In fact, let’s imagine for a second if everyday items were priced in a similar way to APR.
What if, when you went to the pub all the barmaid would tell you is that your favourite lager was £125 a barrel when all you want is a pint? It would be confusing and even rather silly. And judging a short-term loan’s true costs based on APR is a very similar thing.
APR and Loan Length
A short-term loan is exactly what its name says. A loan taken out over a short period of time. Usually no more than a few months and in many cases just for a few weeks. A mortgage, on the other hand, is taken out for somewhere between 15 and 30 years.
This means that the APR on a mortgage loan is lower than a that on a short-term loan, although a mortgage lender can they recoup anywhere up to 100% interest whereas payday lenders only charge 0.8% per day, a much lower representative interest rate than many think.
APR and Risk
There is a reason why you need a great credit rating to secure a personal loan or a mortgage from a traditional bank. They don’t like to take too much of a risk. Any loan is a risk of course, but larger lending institutions minimize that risk by limiting the loans they make to those with demonstrated good credit.
Many short-term lenders – most of them in fact – do consider those with poor credit for a loan. They still take precautions – by verifying that the borrower has a steady income, that they are who they say they are etc. – but by largely overlooking a poor credit rating they are taking a bigger risk.
Any time a loan represents a larger risk, there are likely to be higher interest rates attached. It’s not just loans either.
If you have a poor driving record your car insurance rates are higher until you can demonstrate that you’ve improved. If you live in a big city rather than a small village your home insurance will be higher. And thanks to recent changes in both the law and the industry itself UK short-term interest rates are some of the lowest in the world.
In fact, interest rates have been capped at 0.8% per day, and charges such as a default fee have been capped at £15. This means that customers are better protected than ever when it comes to borrowing a short term loan with the likes of LoanPig and other lenders.
How to Really Judge a Short Term Loan
So, if APR is not the best way to ‘judge’ a short-term loan what is? Here are some of the things to keep in mind and ask yourself when considering taking one out:
What do I need this loan for?
Should you take a short-term loan just so you can go on holiday with your mates? No, probably not. Should you take one so that you can pay something like your rent on time and avoid those inevitable late charges your landlord will slap on? Quite possibly.
Will I be able to pay this loan back on time?
Often a short-term lender will offer several different repayment schedules. Ideally, you should take the shortest as the loan will cost you the least that way. But be realistic. If paying the loan back in 3 weeks versus 3 months is going to leave you strapped for cash again you could be putting yourself in a precarious financial situation.
Do I understand the loan terms?
People hate reading the small print. Do you ever read the agreement Apple makes you sign when you update the iOS on your phone? No, of course you don’t, no one does. When considering taking out any loan though it’s crucial that you do.
A reputable lender lays out all the terms attached to any loan for consumers to read before they ‘sign on the dotted line’. But they can’t force them to read them. That’s up to you.
Before taking a short-term loan ensure you understand everything. And if something isn’t clear, ask. At Loan Pig we build our loan payments on trust, and we never want our customers to default. So we will always do our best to ensure that any short-term loan you take will be beneficial for you, even if we have to answer a hundred questions you might have.