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