Loan adverts will often include an example. This usually includes an amount borrowed, an annual interest rate and a representative APR. For example:
· A payday loan might say: Borrow £500 for 6months – annual interest rate of 65% – Representative APR 91%.
· A mortgage might say: Initial interest rate1.59% fixed, followed by a variable rate of 3.54%, booking rate of £999 and an APRC of 3.3%
But what does this mean? What is APR? Why is it different from the interest rate? What is an ARPC?
In this blog we will aim to demystify APR.
Interest
We assume that you know what interest is. Interest is usually quoted as an annual figure. So, if you borrowed £1000 at 5% interest, after a year you would owe £1,050 (£1,000 for the original loan and £50 in interest). But what you might not realise, is that interest isn’t always charged annually. Instead, interest might be charged monthly or even daily; and this makes a big difference.
If interest is charged more frequently, the interest is added to the balance you owe. This means that in later months you are not only paying interest on the amount borrowed but the previous months interest! This can soon add up to a lot of money. This is called compound interest.
If you want to know more read out blog How does annual vs monthly vs daily interest affect my loan?
This means that the annual interest rate advertised may not actually be the interest rate you paid!
Fees
Some lenders require you to pay a fee. This could be called an arrangement fee or a booking fee…
The fee is charged to either:
· increase the lenders profit on small value and/or short-term loans; or
· grant the customer access to preferential rates.
You can usually pay this fee in advance or have the fee added to the balance of the loan. Remember that if you have the fee added tothe loan you will pay interest on the fee.
Imagine two loans with the same interest rate, but one has a fee. Clearly the one without the fee is the better deal. The fee is notinterest, but it does affect how much the loan ultimately cost you.
For more information on arrangement fees check out our blog Why does my loan have an arrangement fee?
What is APR?
As we have seen, looking at the annual interest rate alone, won’t tell you how much a loan will actually cost you. To enable you to compare loans and get the best deal, you need to think about all the costs of your loan, and this is what APR is for.
APR stands for the Annual Percentage Rate. This is a representation of the total cost of borrowing.
If a loan has interest that is charged annually and no arrangement fee, the APR will be the same as the annual interest rate. But if the interest is calculated more frequently or the loan has a fee, the APR willbe higher than the advertised annual interest rate.
When comparing loans, it’s best to look at the APR.
What is Representative APR
An advert for a loan will often include an example, something like “borrow £500 for 3 months at a representative APR of 85%”. We know what APR is, but what does representative mean? Let’s take a little sidestep.
We are all used to seeing shop sale signs advertising “up to50% off” but when we go in and look only one item has 50% off. In this situation they are using the best sale item to lure you in. A more truthful advert would be “half the items are normal price, a few have 10-20% off, and one item has 50% off”; though this advert wouldn’t be so nearly attractive to sales shoppers.
Banks and money lenders don’t offer all customers the same interest rate. The rate a customer gets is based on: how much they want to borrow, how long for and their credit rating. The money lender would like to copy the shop sale and advertise the cheapest loan they offer, but they are not allowed to. Instead, they must advertise the representative APR. The representative APR is the interest rate that at least 51% of their customers would receive. Some customers will pay less, some will pay more, but at least half will pay no more than this rate.
What is a Personal APR
Simply put, this is the APR that you receive when you takeout a loan. You may get a personal APR that is cheaper or more expensive than the Representative APR offered. The representative APR will help you shop around to find the best loan deal, but it doesn’t mean you will get offered that price. You might only get told your Personal APR when you apply for the loan. When you apply for a loan the lender will often do a credit check; applying for lots of loans to see your personal APR can impact your credit score, making it harder to get future loans. Look for a company that will let you compare loans without recording it on your credit score.
APRC and mortgages
APRC stands for Annual Percentage Rate of Charge. It is designed to enable you to compare different mortgage products. Like APR it accounts for the interest and all fees of the loan.
Because mortgages often provide a lower rate of interest in the early years, followed by a higher rate of interest for the rest of the mortgage, the APRC is designed to reflect this.
Imagine two loans both 25 years long:
· Loan A has an initial rate of 1.14% for 2 years, and then reverts to the standard rate of 4.99%.
· Loan B has an initial rate of 1.39% for two years, and then a standard rate of 4.75%
Loan A is cheaper in the first 2 years, but, due to the higher rate for the rest of the mortgage, it actually has a higher APRC (4.6% for loan A vs 4.2% for loan B)
If you were to keep the mortgage for the full 25 years, it would be cheaper to take out loan B. But… most people don’t just let their mortgage revert to the standard rate. Instead, they would accept the offer with the lower short-term rate and switch deal when it expires. This means that APRC is not that useful to most customers.
Though you should remember that comparing mortgages with different terms, interest rate and charges is complicated, and you should speak to a mortgage advisor if you are unsure.
If you want to know more, read our blog on why do loans vary in APR
