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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.

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  • piceratops seed style avatar for user Benjamin Scott
    At Sal substracts 1 from 1.25^26, why?
    (26 votes)
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    • blobby green style avatar for user Andrew Cook
      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.
      (19 votes)
  • leafers tree style avatar for user Vanessa Jayne
    At Sal says 'usually they would make you at least roll over the principal'. What does rolling over the principle mean?
    (15 votes)
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    • aqualine ultimate style avatar for user Kelsey Gower
      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!
      (19 votes)
  • male robot hal style avatar for user Mostafa Hussam
    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%"?
    (6 votes)
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  • leaf green style avatar for user patrick007_ma
    .Sal makes 2 weeks 16 days.
    (2 votes)
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    • leaf green style avatar for user humancomputerprocessor
      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.
      (24 votes)
  • male robot donald style avatar for user Ethan Nguyen
    Why a payday loan?Why not a regular loan for a lower rate?
    (1 vote)
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    • spunky sam blue style avatar for user L
      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.
      (8 votes)
  • hopper cool style avatar for user Florian Melzer
    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.
    (8 votes)
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  • piceratops seed style avatar for user mark haney
    for credit score, is it better to keep payed off credit cards open or cancel them.
    (2 votes)
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    • male robot hal style avatar for user Andrew M
      Bizarrely, it is better to keep them open, because more available credit helps your score. Also keeping a low ratio of debt balance to available credit helps your score, and keeping the accounts open gives you a better denominator.
      If you are going to close accounts, close them one at a time, and spread it out over time. That way the changes won't pile up in a short time, which would make the change look big.
      (7 votes)
  • starky ultimate style avatar for user ☣MeDaTree☣
    From on, wouldn't you keep loans for WAY less than a year? What's the point of APR?
    (3 votes)
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  • boggle blue style avatar for user x.asper
    What is a pay stub?
    (2 votes)
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    • blobby green style avatar for user Howard Creps
      Basically it is proof of what you get paid from your employer in one form or another.
      If you bank online or use direct deposit, this would probably be in the form of a printout from the site you use or from the bank directly.
      If you receive an actual check, there should be a small detachable "stub" portion that shows your pay or whomever cashes the paycheck can provide proof.
      Usually, showing proof, like with a print out from your bank or check cashing company is a sufficient substitute if you are asked to show your pay stub but to be specific, the stub is the small section that detaches from your pay check.
      (4 votes)
  • blobby green style avatar for user Quilia
    In Canada the Criminal interest rate is 60% (i.e. anything over that is considered a criminal offence). How do these payday loan companies get away from that prohibition in Canada?
    (3 votes)
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Video transcript

I think most of us have a sense that payday loans are probably not the best source for a loan, that they probably charge a lot of money to those people who need that cash really badly. And what I want to do in this video is one, explain what they are but even more do a little bit of math to understand really how bad of an interest that they do charge, So the way that works is let's say that I need to buy my wife a nice gift for her birthday that's tomorrow and I want to borrow $500. So I want to borrow $500. I would suspect that most people aren't borrowing it for some type of a gift, they're desperate to make the rent or pay the utilities or buy food or who knows what else, but whatever your reason, you need to borrow $500 and I would suspect that you have very little in your bank account, otherwise you wouldn't go to the payday lendor. And they say all right Sal, we're open to lending you $500 and we're not going to do all of this deep research on how good of a credit you are and all of that, but we want a couple of things. One, we want to know your pay stub and your pay date. They're going to want to see your pay stub, they're going to they want to know when you're going to get paid, so I guess we call it your payday. And they might want some recent bank statements. And the whole reason why they want these things is they want to know you know even though your credit might be horrible, then you're going to get your salary or you're going to to get a payment from your employer probably in two weeks on your payday, and then you're going to be good to pay back to the $500. And to ensure this, so one they're going to make sure that you have a job, that in your pay stub maybe you make $1,000 every two weeks or maybe you make $2,000 every two weeks so that you're good for this. So maybe you maybe make $1,500 every two weeks, so they like to see that. Maybe your payday is two weeks from the day that you're borrowing it, borrowing the money. So two weeks from today. And then your bank statement shows that your bank kind of goes up $1,500 and you pay the rent and the food and then it goes back close to zero, then it goes up to $1,500 but they want to see that this $1,500 is hitting periodically. And they say, you know, we're going to give you the $500 today. You need to write us a check. We want you to write a check for not $500, for every $100 you borrow, I want you to pay us back another $25. So $25 extra. And at first you might say, that's not bad, that's 25% interest. It's high, maybe it compares to some interest, some credit cards. But this isn't 25% a year, this is 25% for two weeks. And at the end of this video, we're going to do the map on what that actually turns into on an APR, or an effective APR basis. And these numbers are not crazy, these are actually very typical for payday loans. So if I'm borrowing $500, I have to give them back the $500 in two weeks plus $25 for every $100. So I'm borrowing $500, so I'm going to have to do plus five times 25 five or $125. So I'm going to write them a check for $500 plus a $125 so that's $625. I'm going to write a check, but obviously I don't have the money in my bank account right now, otherwise I wouldn't even be going to the payday loan. What I'm going to do on the date, I'm going to forward-date this check. I'm going to put the date, let's say this is the first of the month, instead of let's say, it's January 1, I'm going to put January 16 and whatever year I might be doing it. So I've forwarded it, this is two weeks from today. Two weeks in the future, and then I'm going to sign the check and I'll write it's for a payday loan and I'll write $625 etc. etc., then I have my little information here. And I'm going to give them this check and what they're going to say is we're not going to cash this, we're just going to keep this nice little check for us and when your payday hits you have an option. You can come back to us and give us $625 in cash and then we will give you back this check that is uncashed or if you don't show up, we are just going to cash this check. So one of these two things are going to happen. But effectively, if you didn't lie to them, they're going to essentially charge you $625 and you can imagine it is risky for the lender or because these are people with you know be maybe shady pay stubs and obviously they're desperate, so they weren't good at managing their finances, but they're doing their best to ensure that once that payday comes in, once that's that payment from the employer comes in, that they get first dibs was on the money before the person can pay their rent or their utilities or their food. And so that's the general idea behind it. Now we start off saying this probably not a good idea and you got a sense of that, because we're essentially paying 25% interest for every two weeks, not for every year. But let's think about what that is on an APR basis. So let's say we're paying $25 for every $100, that's really 25 per cent. When you say per cent, that root means hundred, right? Century, 100 years. So per cent, it literally means per 100. 25 per 100, so this is literally 25% interest or we could write it the traditional way, this is 25% interest per two weeks. So if we were just calculate a simple APR, a simple annual percentage interest rate, and you might want to watch the video on that to understand that that just takes your 25% and then multiplies by the number of periods in the year. So we have 52 weeks per year, but this is every two weeks, so instead of multiplying it by 52 weeks, we're going to multiply by there's 26 two-week periods in the year. So times 26 two-week periods per year. And this is 25% per two weeks. When you multiply this out, this is equal to-- let's get the calculator out-- I'll just multiply the numbers, I won't do the decimals. 25 times 26 equal to 650%. We're paying an APR of 650%. So if you thought the credit card companies were charging a lot of interest, charging you a mid teens interest rate or 20% rate, this is 650%. It's an order of magnitude or two above what even credit cards charge. So this is a really, really, crazy annual percentage rate and this was just a simple annual percentage rate where we multiplied it by 26, this isn't the effective annual percentage rate, or the actual mathematically correct one. To do that, we would actually have to take-- and you might want to watch the video on this-- if you were to let that just compound, and you can imagine if you're the payday lender, you are essentially getting that compounding if you keep lending your money out and if you lend the interest you get from the last person, and you lend that out the same rate. To figure out that effective annual percent rate, you do 1.25, 25% plus 1 to the 26th power. We have 26 of these periods in a year. And what is that going to be equal to? So we have 1.25 to the 26th power. And then we get this crazy number, we're going to want to subtract a 1 from it, not that it's going to change much of our math. So minus 1, and we get, well let me be very clear-- essentially this is 329 times our money. So this if this was a one here, that would be 100%. So let me just be clear, this number right here that number right there is such a high number it's hard to fathom. If you were to actually let money compound at this rate, and usually they would make you at least roll over the principal, so this may or may not be accurate but that actual payday lender, if they actually are able to roll over the money at this rate, they're going to have 329 times their money. Or if you write it as a percent, it would literally be 32,987. Literally, 32,987%. Or after a year, you'll essentially have to pay roughly 330 times your money back to the payday lender. And obviously they don't let you compound like that, but this just gives you a sense of how ridiculous this interest rate is. I mean, you might have heard of the term usury. In the past, usury really meant any kind of interest, but now in our current cultural context we associate it with just an unreasonable level of interest and that threshold might be different for some people. Some people might say it's unreasonable to pay 20%, or 30% interest, or 40% annual interest. But I think everyone would agree that whether you look at 650% or 33,000%, these are usurious and reasonable interest rates. So you really, at all costs, unless your life depends on it, you want to avoid these payday loans.