Suppose you are living paycheck to paycheck. Your rent is due on the 1 st of the

Question

Suppose you are living paycheck to paycheck. Your rent is due on the 1st of the month but you don’t get paid until the 15th of the month. Your net paycheck is $3000. So you go to a payday loan company which will loan you $3000 for 2 weeks for a $50 fee.

(a) What is the effective yearly interest rate for this 2 week loan? (Use 52 weeks = 1 year).

(b)People who loan at “exorbitant” rates of interest are known as “loan sharks”. But since the company is technically charging a “fee” instead of ‘interest”, payday loans are not illegal. So if you are living paycheck to paycheck, why would you want to get a loan from a payday loan company after calculating the effective interest rate?

Explanation / Answer

a. Effective yearly interest = (50 / 3000) x 52 / 2 x 100 = 43.33%

b. A payday loan is a small, short-term unsecured loan, "regardless of whether repayment of loans is linked to a borrower's payday." In a perfect world, you’d have a robust rainy day fund for life’s curveballs. But many people live paycheck to paycheck and aren’t prepared for surprise expenses. This is the reason one may opt for such a costlier source of loan.

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