It’s often asked why payday loans are so expensive; with huge annual interest rates sometimes quoted, implying that rich companies are profiting at their customers’ expense.

When investigating why short term loans cost what they do, it’s worth pointing out that it’s very misleading to talk of APR in relation to these kind of loans, as the loans are made over a much shorter period of time.The annualised interest rate is easily in the triple-digit range, but these astronomical figures really bear little relation to the actual cost of the loan products.

Using the same reasoning, you could quote the price of a taxi at £15,000 per 1,000 miles, or £50,000 for a ton of oysters, when no one would actually travel that distance in a taxi or buy that many oysters.

It’s also worth pointing out that banks also compete in this market by allowing unauthorised overdrafts and charging a premium for doing so. More often than not these are more expensive than short term loans.

The fees charged for such online loans need to cover the cost of processing the loan, and the fixed labour and capital costs associated with offering and underwriting a small loan are the same as they would be for a larger loan. The difference is that with a larger loan, it’s easier for the lender to cover their costs and earn a profit by charging a lower annual percentage rate over a longer period of time.

Short term loan clientele often have higher default rates and, because the risk is relatively higher, the risk premium on the loan increases, which adds to the cost of the loan. The interest rates charged on these types of small loans are therefore inevitably going to be higher. Short term lenders must find a way to recover their expenses and earn a reasonable rate of return for providing the service.

For many, short term loans are a cost effective way of handling unexpected or emergency situations. In most cases, these loans provide a temporary financial bridge that can prevent a waterfall of missed payments, fees, and subsequent damage to the customer’s credit.

Because of the expensive nature of payday or short term loans, they should never be used as a primary financial vehicle, but rather as a short-term solution where the flexibility of immediate cash is weighed against the additional cost of procuring such a loan.