Why is Interest on Payday Loans so high?

Payday loans can seem far too expensive, especially when you look at the AER which is the advertised rates. These rates may put you off having a payday loan and you may wonder how they can get away with charging so much. Then when you learn that they charge even more if a person does not repay then this can make you feel even more concerned about it all. However, there are good reasons why they charge as they do and why the AER seems to be such a high figure. It is worth understanding a bit more about it all before you decide that they are just not something that you would consider taking out.

What is AER?

AER stands for Annual Equivalent Rate and it differs form just the interest rate which we will often also see on loans. An interest rate is purely the percentage of interest that you will be charged on the money that you borrow. However, this may not be all that you are paying. Many loans will have additional fees, perhaps admin fees, which all borrowers have to pay as well. In order to make it easier to compare loans, the AER is sometimes used. This adds in the cost of everything that a borrower is expected to pay and then puts it into a percentage. It can be really high and look very odd at times. For some people it can be far better to just ask the lender exactly what you will be paying in monetary terms and compare that figure as it is much more real and easy to visualise compared with a percentage rate.

On a short term loan the AER may be very much higher than on a long term loan. This is because the admin fee tends to be the same, but when it is spread across many years of loan repayments, as it would be with a mortgage, then it is very low, but if you take out a short-term loan such as a payday loan it only lasts for a few weeks so the figure is very much higher. It is all to do with the way the maths is worked out and therefore why looking at it in monetary terms may just make a lot more sense to you.

What is a payday loan?

A payday loan is a short-term loan which usually only lasts a few weeks. It is usually for up to £1,000 and has to be repaid when the borrowed next gets paid. The full balance usually has to be repaid all at once. To make this easier, a direct debit is set up to go out of the borrowers account on their payday and they will be able to then take all that is owed. There is just one repayment, which means that the loan is over with very quickly but you do have to find the money to repay it all at once.

Payday loans were set up to help those who could not borrow elsewhere. This is why there is no credit check. The loans are also arranged very quickly, this is to help out those who need money in an emergency. However, due to them arranging loans at any time, doing it quickly and taking on risky customers, they are expensive. They need to charge enough to cover their losses should they need to. However, they are not necessarily the most expensive type of loan.

Advantages of payday loans

So although the AER looks high on a payday loan, they may not be as expensive as they seem. The cost is relatively high due to the administration charges, but it is always very clear what you will be expected to repay as you can calculate this on their website. As there is just one repayment, you will not have lots of interest to pay month after month and the debt will not linger. You also do not have to worry about whether you have a good enough credit score as this will not be looked at. You will also be able to get the money really quickly, which could be very useful if you need it for an emergency purchase or to pay a bill or something else with a very close deadline.

So, although the interest is high there are reasons for this. The lender is taking a risk but it means that those who would not normally be able to borrow money will be able to get some if they really need it. You also have to repay quickly which is different to some other loans, like credit cards and overdrafts where the debt can be held onto for a long time. Although the idea of flexible repayments can be attractive, it can mean that you will end up repaying over a very long time period which can make the interest really add up and the loan very expensive.

Should I use a Credit Union Rather than a Payday Lender?

Generally, we may have heard bad things about payday lenders and good things about credit unions and this may make us think that we should use a credit union over a payday lender. Although this could be beneficial to us, there are fundamental differences between how the two work and so it may be that one is much more suitable to your needs than the other. It is worth finding out more about how each of them work so that you can decide which one you think will be best for you.

Credit Unions

Credit unions tend to be local lenders associated with a group. They might be run by a local church, for example and they will have restricted membership. It might be that you will have to be part of the group in order to be able to use them or that you have to live in a certain area. Some local areas may have more than one with different joining criteria. If you are interested then you will need to find out whether there are any local to you and if you are able to join.

Credit unions tend to run as non-profit companies and their staff are often made up of some volunteers. This means that they do not have the same costs as regular lenders and they can therefore lend at cheaper rates. However, they may have criteria attached to lending. Some will want you to have been a member and making regular deposits into a savings account for a certain amount of time and others may require you have a certain level of savings. All rules will be different and so you will have to contact them to find out.

They will often be prepared to lend to those who do not have a good credit rating or have been turned down for loans elsewhere. As they deal with each case individually then they will need to talk to you and ask you to explain how much money you need and how you plan on repaying what you have borrowed. They may even set the number of repayments to suit your budget. They will then have to apply for you and it may take a while before they can get back to you and let you know whether you can have the loan or not. You will probably have to go to the local branch to discuss it with them and some are only open a few days a week during normal working hours. You will therefore need to make sure that you are available at this time.

Payday Lenders

Payday lenders normally lend to anyone in the UK as long as they have a bank account and an income. There are likely to be a lot of different payday lenders that you will be able to choose from. It is usually very easy to apply for a loan with them online or over the telephone and some can arrange those loans within a few hours. There may be some that have local branches, but this will depend on where you live and whether you have high street lenders. There are more to choose from if you look online. You will have to prove that you have an income so that they can set up a direct debit on the day you get paid so you can repay the loan in full on the day that you get paid. This can be good as the loan does not last long, but it can be harder to manage the repayment as you will have to find it all at once. You also then need to manage for a whole month until you are next paid on significantly less money.

Which is best?

It can be very difficult to choose between these lenders but it will depend on a number of factors. Obviously, you will need to have a local credit union that will accept you as a member and lend you the money that you want and you will have to be available at the times that they are open to arrange it. You will also need to be prepared to wait a while for the loan to be organised. A credit union tends to lend at lower rates and you will have more flexibility over repayments. They will want to set the repayments so that you can afford them.

A payday loan can be set up much more quickly and they are more likely to accept you. You will also be able to choose between lots more lenders. However, they are likely to be more expensive and you have to repay the loan in one lump sum, which can be tricky to manage.  

So which is best can depend on what is available to you, how quickly you need the loan and how easy it will be for you to manage the repayments.