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APR or Annual Percentage Rate was brought in as part of the consumer credit act in 1974. It may also be known as Nominal APR, Effective APR and most recently Representative APR. It shows the interest rate on a loan for the whole year and it attempts to standardise the true cost of borrowing as a form of consumer protection. This means that it is easy to compare lenders and loan options. By law the APR HAS to be shown by all lenders of all consumer products in the UK. Credit card companies are a slight exception. They are allowed to advertise a monthly interest rate but they MUST tell you what the APR is before any agreement is signed.
Is the simple interest rate for the whole year. This means that if a monthly interest rate is shown, the nominal APR can be calculated relatively simply by hand using a pocket calculator.
e.g. If you take out a loan for £100 at 5% per month and repay it after one month the nominal APR can be calculated as follows:
5% x 12 = 60%
So the APR is 60%
Although it is really easy to calculate it isn’t really that useful because it hides certain things such as fees that might be payable and also the compounded effect of interest if the loan is paid back before the interest falls due.. That’s why in the UK when we talk about APR we generally mean:
This includes fees and the compounding effect of interest. The manual calculation for this figure is much more complex than for nominal APR. We show two quick examples – just follow them through but don’t worry about remembering the calculation – we have included a link to a handy calculator http://www.prudentminds.com/apr-calculator.html for you so that you can begin to work out effective APR’s for yourself really easily. There are several types of fees, which are included in an APR calculation. These may be start up fees, final redemption fees, early closure fees or late payment fees. Although its worth knowing what these are, don’t be too worried if you can’t remember them – you can always refer back here if you need to look them up.
If you take out a loan for £100 at 5% per month and don’t repay it for one year and there are no fees involved the effective APR can be calculated as follows:
Where 1 is the principal amount and .05 is 5% or 5/100
(1.05)12 which is (1.05 x 1.05 x 1.05 x ......... 12 times) = 1.7958
1.7958 - 1 = 0.7958
The effective APR = almost 80%
This means that the APR has gone up by 20% because the loan was repaid much later – this is because of the compounding effect of interest. So you will have to pay almost £80 interest on a £100 loan!
If we assume that there is an arrangement fee of £10 which is payable at the end of the loan it means that amount you will have to repay is £80 + £10.
Now the APR becomes 90%!
From 2010 representative APR has replaced effective APR in the UK.
Don’t worry, the calculations are the same but it means that as well as showing the APR in any advert there must also be a clear, concise example which is more prominent than the information. This applies to all consumer loans under £60,260.
The rate quoted in the lenders advert must reflect at least 51% of the business expected to result from the advert. This means that if an advert attracts 100 new customers then at least 51 of them must be offered the advertised APR.
One size doesn’t fit all
The APR that is applied to credit cards or loans varies from customer to customer. This reflects the risks involved and falls in line with the credit rating of the borrower. This means that even if you see an advert where the representative APR is 20% that won’t necessarily be the rate you will have to pay. Remember, as long as 51% of the customers reading the advert get the advertised rate then the lenders are completely legal.
APR and the total cost of borrowing
Because APR brings everything down to an annual basis it is not a good indicator of the total cost of borrowing.
Very short term loans such as those advertised on wonga.com have a ridiculously high APRs. Remember they HAVE to show the ANNUAL percentage rate even though these loans may be repayable in a maximum of 4 weeks. This means that because it is a short term loan the actual cost of borrowing maybe quite low despite a huge APR. On the other hand mortgages may have relatively lower APRs but because the duration of the loan may be 25 years or more the actual cost of borrowing may be several times that of the original loan.
Interest only loans have a very high APR because the principal isn’t repaid until the very end of the agreement – these generally have a high cost of borrowing as well.
0% finance as you might expect have low APR (not necessarily 0 as there may be some fees involved) but they are generally a cheap way to borrow money.
How else APR can be misleading.
When an APR is calculated it is assumed that the loan is kept for the lifetime of the loan agreement. Early prepayment may well bring the APR and the cost of borrowing crashing down but remember there may be some fees associated with this.