There can be a large difference in the APR that loans have. At the time of writing the best mortgages deals have initial rates of 1.5% to 2.5%,whereas Money Advice Service report that, the average payday loan has an APR of 1,500%! If you are not familiar with what APR is then check out our APR explainer blog.
Why is it that the rate can vary so greatly? In this blog we will see all the things that can affect a loans’ APR.
Arrangement fees
We won’t go into details of what APR is, but it’s worth remembering that APR includes any arrangement fees charged. Imagine two loans for the same amount of money, with the same term, interest rate and monthly repayments. If one of these loans has an arrangement fee, it will have a higher APR than the loan without it.
Secured vs unsecured loans
There are two main types of loans: secured and unsecured. A loan that is secured against an item is safer for the lender, than an unsecured loan. This means that there is more chance that they will get their money back, even if you stop paying back the loan. As a result, secured loans are usually cheaper than unsecured loans.
What you are using as security/collateral
Collateral is the term given to items you have put up as security on a loan. Not all items are equal when it comes to how well they work as collateral. It will be easier and cheaper to get a loan using items that are ‘good’ collateral.
Loan to value ratio
If you don’t make payments on your secured loan, the lender will repossess your assets to get their money back. The Lower the LTV, the higher the chance that the bank will get their money back. A low LTV is a safer loan for the lender and as a result, they are willing to lend you money at a lower interest rate.
Credit score of borrower
Technically this doesn’t affect the advertised representative APR, but it will affect the personal APR you are offered.
Your credit score is a prediction of how likely you are to pay back money you have borrowed. Lenders will usually check your credit score when you apply for a loan. They use this information to work out how profitable a customer you will be for them. If you have a bad credit score, they will worry that you won’t pay the money back and will charge you a higher APR.
See our blog on understanding and improving your credit score.
Guarantor
If you have a poor credit score, then having a Guarantor improves the risk of the loan for the lender. The lender can afford to offer the loan at a lower APR than they would have to the borrower alone.
The lender does have additional costs in offering these types of loans e.g. performing credit checks on the borrower and the guarantor.
Guarantor loans have lower APR’s than people with a poor credit score could get on their own, but never as good as someone with a good credit score would get.
Very Short-term loans
Lenders have to find customers, and this costs them money. It will cost them twelve times more to get twelve different customers that want to borrow money for a month, as it will to find one customer that wants to borrow money for a year.
On top of their advertising cost, there are costs to provide the loan: staffing, IT systems, rent…
Let’s look at two scenarios where a lender provides £10,000worth of loan at 10% interest. In the first situation they lend the money to 1 person for a year. In the second they lend the money to twelve different people, each for 1 month. In the first scenario the lender receives £550 in interest. In the second scenario they receive £960 (£80 from each of the customers). This would first suggest that the second scenario with short term loans is more profitable, but that doesn’t factor in the additional costs. It’s easy to see how the first scenario becomes more profitable once the costs are factored in.
And this doesn’t account for the fact that in the first scenario, the lender can start making loans to additional customers once part of the first loan is paid off; increasing the profitability.
This means lenders need to charge you a higher APR to make profit from very short-term loans.
Very long-term loans
The economy goes from periods of boom to bust. It’s much easier for lenders to predict what will happen in the short and medium term, than the long term. The longer you want to borrow money for, the more uncertainty there is on your ability to repay it.
It’s not just your ability to repay that becomes more uncertain in the future. Governments could change regulations, the lenders costs could increase…
Some lenders will charge higher APR’s for very long-term loans to account for this uncertainty.
Low value loans
In the same way that very short-term loans are expensive to provide, it is relatively more expensive for lenders to provide low value loans.
If you loaned £10,000 to one customer, you have one set of costs. If you instead gave one hundred customers loans of £100, you have one hundred times the costs.
Low value loans are more expensive to offer and so to make money the lender must charge a higher APR.
Infrastructure required to lend money
Not all lenders have the same costs:
· Large banks have a regular supply of loyal customers, that the bank understands, who can use online self-service loan applications.
· Payday lenders must invest heavily in advertising to get a constant stream of new customers.
· Pawn shops have high street shops to physically hold onto your items (and sell if you don’t repay the loan), and they have high staff numbers to value your items.
As a result of this, different lenders have different costs to cover when you take out a loan. The higher the costs, the higher the APR the lender needs to charge to make money.
Summary
There are a range of items that can affect the APR that you get offered. Although we have explained the main details of how each can affectthe APR, each loan is a different combination of them. It is this unique combination that ultimately sets the APR the lender charges.
Added to this, every lender has different target customers. Some want to make lots of low value unsecured loans, others want to make long term secured loans…
When looking for a loan, you need to identify lenders that are advertising loans that are like the loan you require. Next you should shop around and look for the best APR you can find.
And if the APR you are offered is not good, maybe it’s time to:
· Review your budget to see if you can make do without the loan.
· Decide if you really need to spend the money now.
