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APR explained – understanding the annual percentage rate
When you’re looking at loans, one of the most confusing things to get your head around is the annual percentage rate, or APR. It is also one of the most misunderstood.
All payday loans will be advertised with the APR clearly shown. If a lender does not tell you the APR, then avoid them, as they are breaking the law.
Those three little letters – APR – will appear on information about any financial product you have ever used. But what exactly is APR? How does APR work? Why does APR matter? And how does APR affect the financial products you use and how much they will cost you?
Often lenders do not fully explain what APR is and how it works. But you don’t need a degree in maths to understand APR and what it will mean for your borrowing. Some simple basics will help you to work out how APR is applied to credit and how to use it to make choices around lending.
What is APR?
APR stands for Annual Percentage Rate. It is a single figure which represents the cost of borrowing if credit was taken over a year. It is expressed as a percentage of the total loan.
APR is not exactly the same as the interest rate, so it is important to understand the difference in order to evaluate the cost of a loan, credit card or overdraft.
APR is the way lenders describe the cost of borrowing money over a period of one year. It allows you to compare the cost of loans from different lenders.
By law, all lenders must declare the APR on their products before an agreement to lend money is made. Lenders must display the APR on each credit line they offer on their website, marketing material, legal agreements and documentation.
This allows there to be complete transparency when taking out a loan so borrowers know how much they will be repaying and which deal is best for them.
How APR works
Every lender calculates APR in the same way. The higher the APR, the more you will pay for a loan overall. There should be nothing hidden in the advertised APR which would mean it is actually higher than the figure you see presented.
APR takes into account:
- The interest rate you will pay;
- How often you make will payments;
- Any other charges.
The charges included in APR can include broker fees, closing costs, rebates, and discount points. These are often expressed as a percentage.
If a loan of £100 has an APR of 100% it does not mean that you pay back £200. This is because you pay interest on the balance of the loan as it goes down as it is being repaid.
So each time you make a payment, the balance goes down and the interest is calculated on what is left. The interest is compounded.
This continues until you repay the loan. As payments are normally the same throughout a loan, you will pay off less of the balance in the early days.
Using APR to compare loans and other credit
It is important to be able to compare like-for-like when it comes to choosing a loan and the interest rates that apply to it.
This is where APR comes in. It makes sure you comparing apples with apples and not comparing apples with oranges.
What affects the rate of APR?
The rate of APR charged by the lender may vary and will depend on:
- The lender’s rates;
- The borrower’s circumstances and their credit score;
- How long the loan is taken out for – the “loan term”.
Loan and credit providers have the choice of how much they wish to charge for their products. Some financial sectors such as the payday loans industry have a maximum price cap. But lenders will have different rates of APR depending on things like their competitiveness against other lenders, the risk of borrowing and the costs they have to cover.
The borrower’s circumstances and financial situation will often impact on the rate of APR that they are offered.
For applicants with bad credit, the lender may need to charge a slightly higher rate to manage the risk that they won’t get their money back. Equally, if a customer has a good credit rating, the APR may be lower because they are considered less risky to lend money to.
What is the difference between fixed and variable APR?
A fixed rate of APR means that the rate charged will not change throughout the loan term.
The rules – as set by the Financial Conduct Authority (FCA) in the UK – say that payday loan lenders must not have a daily interest rate of greater than 0.8%. So if you took out a payday loan of £100 for one day, you would repay £108.
For payday loans, this rate must be completely fixed and will not change unless the customer falls behind on payments and is required to pay late fees.
A variable rate of APR reflects a rate that changes based on national rates or economic changes.
For example, it is common to see a mortgage rate that is fixed to the Bank of England’s Base Rate. So it is actually a variable rate of APR. If the base rate goes down, the customer will pay lower mortgage repayments, and vice versa.
What are representative APR and typical APR?
Representative and typical APR are two different ways of working out and presenting APR.
When lenders use the expression “representative APR” they are referring to the rate that 51% or more of applicants for their product will be offered. This rate includes all interest, fees and compulsory extras including things like obligatory insurance policies. Representative APR is intended to give you an idea of the rate applied, one that will apply to just over half of customers.
When lenders advertise a “typical APR” they are referring to a rate which, by law, two thirds or more of applicants for their product will be offered. Again, the rate includes all interest, fees and additional charges. Typical APR is the rate which will apply to most – or the “typical” – borrower.
APR on loans that are for less than a year
Even if the loan term is less than a year, the APR shown will be worked out over as if the loan had run for one year.
The APR will still help you to see if the loan is expensive or not, but you could also look at the total credit cost to see exactly how much you will pay back.
Why do small loans like payday loans have higher APRs than banks?
The APR for payday loans tends to run in the thousands of percent and this can initially look quite off-putting. But it is important to fully understand APR in order to understand how much you will pay back on a payday loan.
The reason why the APR figure for payday loans is so high is because they typically only last for a few weeks – usually less than a month, and in some cases, just a few days. But to express the cost as an Annual Percentage Rate, the interest is compounded again and again to show what it would cost as if the loan were taking out for an entire year, making it seem much higher than it is. But the loan isn’t taken out for an entire year.
Also, the small loan market is different from that of the big banks. The large high street lenders often don’t lend smaller amounts of less than £1,000. This is because the amount they would earn from lending is too low to cover the cost and to make them a profit.
The big lenders often only offer loans to people with high credit scores. The banks consider it riskier to offer a loan to people whose credit rating is poor. Big lenders can be picky about who they lend money to, so they can choose not to lend to people with lower credit scores.
When a small loan is offered, costs include:
- Checks that the loan is appropriate for the person borrowing the money – that they can afford to make repayments and that they will be on time;
- The risk that some loans may not get fully paid back.
A loan of £500 and a loan of £3000 cost similar amounts for lenders to give out. But the actual interest paid on £500 – and so the amount the lender receives back – will be much less than the interest paid on £3000, so the APR needs to be different to make it worthwhile making the loan.
This can actually be particularly confusing when it comes to payday loans. There are situations where the APR can be significantly higher on a short-term loan than on a longer-term loan but it will actually cost less overall. Due to the intended short nature of a payday loan, the APR can look quite large, but the overall cost is not.
If APR isn’t a particularly good indicator for payday loans, what should I use?
Since the APR can be misleading when comparing the cost of a payday loan, there are other measures that can be used.
Most lenders are required to provide a repayment example, which gives you an idea of the amount, the interest you will be borrowing and how long for. This can provide a more practical example of how much your loan will cost. It will make sense to almost everyone.
Other measures include the daily interest, which on payday loans is capped at 0.8% per day. There is also a limit that can be charged on loans of £100 over a 30-day period. This is capped at £124.
So if you take out a payday loan of £100, you will not pay more than an extra £24 when you repay it after 30 days. That is quite reassuring for people who need to borrow short term cash to cover emergencies or other unexpected expenses.
The Bottom Line of APR and payday loans
While the interest rate determines the cost of borrowing money, the APR is a more accurate picture of total borrowing cost because it takes into consideration other costs associated with taking out a loan.
When determining which loan provider to borrow money from, it is crucial to pay attention to the APR. The APR is the real cost of borrowing – but remember it is reflective of a loan taken over a period of a year. Take the time to investigate the APR of different products and payday loans.
Not everyone can get the help they need from a bank, building society or credit union. Responsible payday loan lenders will try to help people with less good credit scores get smaller loans.
This can give many more people access to much-needed funds. The cost of a payday loan does not need to be prohibitive, provided you borrow only as much as you need and make repayments on time.
Because APR can look a little confusing when considering a loan for less than a year, a better way to appraise and compare the affordability of payday loans is to work out the interest you will be charged per day, or per £100. This is a figure we can all understand. Remember to factor in admin fees and charges when you work out the cost of borrowing this way.
But, the bottom line is that the FCA rules say that you will not pay more than £124 on a loan of £100 over 30 days. This actually makes payday loans look a lot more reasonable than some people think.