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Payday loans have become popular sources of emergency funds for many people because they are fast and easy to get. However, there have been complaints about the high interest rates that loan companies charge for such a short-term loan. These loans only have a duration of 10 to 14 days or they are due on the next payday. Thus, when the effective annual rate is calculated, it could be an average of 400 percent or even as high as 650 percent. The problem is that this is not obvious because the interest and other other charges are often just expressed in terms of dollars.

How to compute the annual rate for a payday loan

Estimating the cost of a payday loan is quite simple. The first step is to get the total of all interests and charges. This is the total cost of the loan but we must transform this into percentage annual cost to be able to compare it with other kinds of loans. To get the percentage annual cost, the first step is to divide the total cost by the loan amount. The value obtained is the percentage of the cost compared to the loan amount. To convert this to annual rate, we have to divide 365 days by the duration of the loan in number of days, and then multiple the result with the percentage that we had previously computed. This is now the annual cost of the loan.

Example calculation

Let us now take a concrete example. Let us say that the total charges for a $500 payday loan is $80. Then, the first calculation will be 80/500 or 16 percent. Let us now say that the loan term is 14 days. Therefore, the ratio of 365 days over 14 days is 26.07. When we multiply this to 16 percent, we get the value of 417 percent. Thus, the annual cost for this particular payday loan is 417 percent.

Comparing a payday loan to a cash advance

Let us now compare the annual cost of a cash advance to that of the payday loan. Let us say the a cash advance of $500 will incur a total cost of $7.00 after calculating the interest and other charges. The percentage of $7 over $500 is 1.4 percent. Assuming that the cash advance also has a duration of 14 days, we then multiple this value by 26.07. Thus, the annual cost of the cash advance of the same amount is 36.5 percent.

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