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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.

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