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### Course: Personal finance>Unit 3

Lesson 4: Credit cards and loans

# Payday loans

Payday loans, which are sometimes called cash advances, are a form of unsecured short-term loans that are typically associated with very high interest rates. In this video we explore an example of a payday loan and use that to better understand the defining characteristics of a payday loan, and how they translate into an effective interest rate. Created by Sal Khan.

## Want to join the conversation?

• At Sal substracts 1 from 1.25^26, why?
• Imagine instead that a lender charged Sal 25% interest on a 1 year loan instead of a 2 week loan. To find the APR, we'd take (1.25)^1, which would be 1.25. If we didn't subtract 1, we would incorrectly conclude the APR is 125%. The correct APR is 1.25 - 1 = 0.25, or 25%.

To answer your question, the "1" represents the original loan amount. Think of it as 100%. In my example above, Sal owes 100% of the original amount of the loan plus an extra 25% due to interest.

The same concept applies to larger exponents. For example, if the loan was a 26 week loan, we'd take (1.25)^2 = 1.625. The APR would be 62.5%, which comes from 1.625 - 1 = 0.625. Sal would owe 100% of the original loan amount and an extra 62.5% of interest.
• At Sal says 'usually they would make you at least roll over the principal'. What does rolling over the principle mean?
• The principal is the amount of money loaned, in this case \$500. Rolling over the principal in this case means paying just the interest on the loan, and maybe an extra fee and then the store will essentially start the loan over with the same terms. So, if someone took \$500 and paid just the \$125 interest amount to roll over the loan every two weeks for a year, they would have paid \$3250 in interest! And they still wouldn't have paid off the loan!
• according to Sal's example in the video, the interest is 25% per two weeks, that means 50% per month, which should mean %600 APR (50% * 12 month)
why is this result different than Sal's one "650%"?
• That's because Sal puts that one year has 52 weeks. And it has. With your example a year has 4 weeks x 12 months = 48 weeks. 4 weeks disappear in your example. There are the missing 50% APR in your example - because of the tricky 5 weeks months ;-)
• .Sal makes 2 weeks 16 days.
• The payday was two weeks away starting on the next day. If he got the loan the night before after 5pm, January 1 wouldn't really count. On January 15, he would receive his paycheck, but that may take a few hours to clear. That is why many deposit slips may say, "deposits may not be available for immediate withdrawal". If he deposited his pay check at the end of the day after leaving work on January 15, the deposit may not be available to be withdrawn until after the business hours of the payday loan business. So, they would need to cash the check either after business hours, or at the beginning of the next day. Either way, they wouldn't be able to re-lend that money until the next day.
• This must be a very old video, considering there are people who wrote questions 10 years ago! I figured this whole course was brand new. I guess not.
• The course reconfigured existing things (like this video) and added new material. Not everything here is new, but it's all valuable. Consider it as if in your city a new art museum were to be opened. It's contents would include old stuff and new, so it would be a valuable place to visit.
• Why a payday loan?Why not a regular loan for a lower rate?
(1 vote)
• Probably most people who are taking out a payday loan feel like they have few or no other options, due to having borrowed too much already, having no checking or savings account, having unemployment or under-employment issues, medical expenses, and other reasons. They might have no access to a regular loan for a lower rate. Also, they might have access to other options, but just not know what to do to access them, or even how bad of a deal the payday loan actually is. Thanks to Khan Academy and other educating websites, some information about all of this can be more easily found.
• In this example Sal simply did (1.25)^365 in order to find the APR. But what I did (and what mathematically should've been correct as well), was to figure out the percentage that is compounded per day.So I took 650/365 and got approx. 1.78%. Then I took this percent and did (1.0178)^365 and got approx 626.135. Why was my value for the APR so different from the one Sal got (approx. 329)?
I want to know why my method got me the incorrect APR, because in Sal's video about APR's he used this exact same method.
• 1.78 its per day, if you multiply 1.78 x 14 (14 days) = 24.92%

24.92/100 = 0.2492
1 + 0.2492 = 1.2492
1.2492 ^ 26 (numbers of periods money increase) = 325.4
• 32,987% interest rates ... is that even legal?
• Usury protections in the Texas Constitution prohibit lenders from charging more than 10% interest unless the Texas Legislature specifically authorizes a higher rate. Payday and auto title businesses have found a way around the constitutional protections by exploiting a legal loophole.

The maximum permissible interest rates in Florida are 18% per annum simple interest for loans up to \$500,000.00, and 25% per annum simple interest for loans of \$500,000.00 or more. Note that those figures represent simple interest per full calendar year.

North Carolina interest rate laws set the maximum rate at 8 percent, but explicitly allow consumers and creditors to "contract for a higher rate." State law also exempts mortgage loans, equity lines of credit, and some other types of credit from the statutory limit.

Arizona's Usury law limits interest rates at 10%. If a bank or lending institution charges more than this interest rate, it will incur penalties.