Thousands of borrowers turn to lenders for short-term loans, whether to tide them over until the next payday, or to cover an unexpected bill, but a significant proportion are unaware of the actual costs of borrowing, or are confused by APRs, fixed and variable interest rates and representative examples.
While there are regulatory caps on the interest consumers can be charged per day, and on the total cost of a loan, the maximum remains double the amount borrowed. Therefore, a £150 loan could cost up to £300 to repay, which may be far more than anticipated.
This guide clarifies the terminology and phrases used in lending applications and loan agreements and explains how to calculate the true cost of a payday loan, both in terms of repayments and the overall cost of debt.
Reasons UK Consumers Need to Understand Borrowing Costs
Credit is widely available and often perceived as an easy solution, with options such as buy now, pay later offers at checkouts, digital loan applications, and accessible payday loans.
Despite varied regulatory reforms, concerns persist about ongoing cycles of debt. A reported 84% of UK adults use some form of borrowing, 14% of the population requires debt advice, and 22% are at risk of falling behind and relying on high-cost borrowing for essentials.
Knowing what a loan will cost is essential to help households budget for repayments and avoid borrowing more than they can afford, which inevitably leads to issues keeping up with repayments. This can contribute to further problems and additional costs, such as late charges, penalties, and negative credit scoring.
In addition, some payday loans require a lump-sum repayment rather than the regular repayments borrowers may expect, making clarity even more important to protect their financial well-being.
Loan calculators and other resources, such as those available free of charge from Cashfloat, can help with decision-making and demonstrate how the specifics of a loan will impact the costs. Prospective borrowers can use these tools to compare products and lenders and review how increasing the repayment term affects their instalments and the total repayable.
Factors Influencing the Real Costs of Payday Borrowing
One of the biggest issues with financial literacy is the jargon and phrases lenders use. Language may be accurate, but it might not necessarily be straightforward for every borrower to understand, especially those from vulnerable demographics or with little financial education.
APRs, Representative Examples and Interest Rates
Loans are financial products that banks and lenders want consumers to apply for. Although they must follow regulatory rules on how these products are advertised and sold, it is the borrower’s responsibility to read the fine print carefully before applying or signing a loan agreement.
Representative examples are not always the rates that a borrower will be offered. Instead, they indicate the types of interest rates offered by the lender, based on a rate that 51% or more of applicants will receive.
However, borrowers with adverse credit or other eligibility issues can be offered higher interest rates if they are regarded as higher risk.
The annual percentage rate, or APR, differs again and includes fees and other costs borrowers are expected to pay alongside the interest on the debt. This figure helps consumers compare companies and products, but it is not a guarantee that every applicant will be offered the same rate.
Finally, the interest rate shown on a formal loan offer is the amount that will be charged on the borrowed amount, although it excludes other charges such as arrangement fees.
Payday Loan Durations and Repayment Costs
Payday loans are intended as short-term products, designed to provide a way to borrow small amounts to cover expenses until the borrower’s next payday. As a result, these loans already carry shorter durations than alternatives, particularly secured loans and mortgages, which usually last several months or years.
Applying for a payday loan with a minimal repayment period means the debt will be repaid faster, and the total repayable will be lower, but each repayment will be higher. Payday loans that must be repaid in a single lump sum will usually attract lower interest if the repayment date is sooner.
In contrast, a longer loan term will normally mean the overall debt costs more, but the instalments made are lower, which can be appealing to borrowers with tight budgets who want to ensure repayments are manageable.
For example, borrowing £500 for three months at an APR of 1296.2% would mean repaying £234.10 a month and £702.20 in total, paying £202.20 in interest on top of the amount borrowed.
If the borrower were to extend the same loan to four months, their APR may fall slightly to 1253.7%, with lower monthly repayments of £192.05. However, the loan would cost £768.20 to repay, an extra £66.
It is important that consumers know how this works and can both afford the repayments and manage their finances to avoid needing to apply for further borrowing before the loan term ends.
The Impacts of Eligibility Criteria on Payday Loan Costs
Loan applicants have varied circumstances, and lenders must ask questions about their age, employment position, income, and credit history.
Applicants will usually be asked to consent to a ‘soft’ creditworthiness assessment initially, which isn’t recorded and provides a potential lender with some basic information about their credit history.
Hard searches, performed once a borrower submits a formal application, are displayed on the individual’s credit file, which may have consequences. If, for instance, a borrower applies to multiple lenders and there are numerous searches on their file, this can make them a less desirable applicant, increasing both the chances of rejection and the interest rate they are likely to be offered.
Each lender will apply its own lending policies, which determine whether a borrower will be approved. However, anything viewed as adverse, such as a low income, irregular employment, or a recent job change, may mean paying more for a payday loan.
Prospective borrowers considering a payday loan are advised to review the terms and charges carefully and are encouraged to use free online resources and calculators. Those with concerns about their finances should seek support from an organisation like StepChange or the National Debtline.
