You see APR all over the place when it comes to money. The banks and lenders have it plastered across leaflets and webpages. But what does it mean in simple terms? And more importantly, why do we need to have a clear knowledge of APR?
What is APR and why do we need it?
The first thing to know is that understanding APR can help you save money. So it is worthwhile having a clear knowledge of what APR is. Very simply, APR is a comparative measure to help understand different loans. But this knowledge alone is not enough to really use APR when deciding which loan to take.
In this article, we will explain more deeply what APR is, and how can we use it in order to identify a better deal. Before going into the explanation of APR, we will review some of the basic terms that need to be understood before talking about APR. If you have already read these in one of our other guides, or know it from your general knowledge, you are welcome to skip this section and go directly to the in depth explanation.
The simplest definition of a loan, is a financial deal in which one party gives a sum of money to a second party for a limited amount of time. After this period, the second party needs to return the same sum back to the first party. This type of loan is called an ‘interest free loan’. It is rare to find these types of loan, but they can be found being given by nonprofit organizations, for example. Most of the loans we encounter in real life are loans that need to be paid back with interest.
What is interest?
Most times when taking out a loan, the sum that we return is bigger than the sum we borrowed. The difference between the sum we took and the sum we pay back is called the interest. The amount of the loan that we took in the first place is called ‘principal’.
There are many ways to calculate the interest. The most common way is by adding on a percentage of the loan (called the ‘interest rate’). For example, if the interest rate is 10% and the loan is for £100, the interest is £10, and the amount to pay back is £100 + £10, which gives us £110.
|Simple Interest||Compound Interest|
|Interest Amount||Amount to Repay||Interest Amount||Amount to repay|
The difference between simple and compound interest seems to be small for a five-month loan. However, as the number of the months increase, the difference becomes bigger. After a year, for example, the value of a compound loan would be £313. In contrast, the value of the same loan built on ‘non compound’ interest, would have a loan value of only £220. We can now see that the difference is much more significant.FCA: All loans given in the ‘high cost short term’ market after 02/01/2015 must be ‘non compound’ loans Click To Tweet
The FCA put the above regulation into place in order to protect clients from falling into the ‘compound interest’ trap. Furthermore, if the customer pays the loan in several instalments, the interest is calculated only on the current balance of the principal. This is also for the benefit of the client.
Payday loans APR calculation
Responsible lenders in the UK only provide loans with simple interest charges. With the introduction of the FCA regulations for payday loans and short term loans in 2014, the use of compound interest for consumer credit has been denounced. As well, the use of rollovers has been limited, and a cap was introduced to the overall charges allows.
Why do we need to know about APR?
But APR is still a tad confusing as lenders can interpret the definitions in different ways. Would the collected money be used to pay back the intial amount borrowed or the interest that has accrued on the loan? When working with payday lenders, it is always recommended to understand the APR structure they use to calculate the repayment plan. Equally important, what are the agreed repayment plan options they offer and how the interest applied to each option.
Apr vs interest rate
Do you know the difference between APR and interest rate? Do you think they are the same? The APR includes additional fees that you might be charged on top of the interest rate. If your unsecured short term loan UK lender agreed any additional fees with you, these will be included in the APR. The APR represents the total cost of the loan to you, explained on a per year basis. Naturally, you won’t be taking short term credit for a year, so you have to learn what the figure will mean for you.
Cashfloat brings you information to help you when navigating APR and different loans. This can be very confusing, yet we aim to make the subject as clear as possible. When you take out a payday loan, you may want to know what the total cost will be for you, in a way that you can use to compare between another payday loan. The FCA has instituted a new regulation, that payday loan providers must offer a comparison with a competitor company, so that you have free choice when it comes to choosing a same day funding payday loan. One way to compare is by using the APR. Of course, there are other important things to consider, such as customer service and reliability.
Understanding the APR term
So what is APR?
APR is a comparative measure to help compare loans. We have seen that understanding the details of a loan can be tricky in some cases. Each loan might be different; therefore comparing them can prove problematic.
In order to solve this problem, and to allow people to compare loans, a parameter called APR was invented. The idea behind this parameter was to give people a quick way to know which loan offer is more expensive than others are. The factors of the parameter include all the costs, including bank fees, lawyer fees and any other costs.
APR and Chocolate
We can put this into perspective by comparing this parameter to an everyday example: You can think of it as the same idea as comparing the amount of calories per 100 grams of different food products. Once this parameter exists, it is very easy to compare apples, chocolate and rice pudding no matter what the size of the package is.
The official definition of APR is: “The yearly interest payable on the amount borrowed plus any other applicable charges all expressed as an annual rate charge”.
In other words, this is the interest and expenses you would pay if you would take a loan, and repay it in a year. For example, if you borrowed £100 and the loan APR is 56%, after a year, you would pay back £156 in total.
It is important to note that APR is not a magic parameter that solves all our problems. We must take into account that using APR in order to compare ‘compound’ and ‘non-compound’ loans is problematic, as we will see below.
The FCA published a formula for the calculation of APR. The published formula relates to compound loans only. At the time of the writing of this article, the FCA has not yet published a formula for calculating the APR of ‘non-compound’ loans. Hence, at the time of the writing of this article, this is the standard in the industry and hence we do supply this parameter, even though it is wrong.
In order to really see and compare between short term lenders, we advise our readers to look at the P.A. parameter. This parameter actually gives the right calculation for annual interest, and can be used in order to compare between ‘non-compound’ loan offers.
As you can probably imagine, not all clients are equal. There are clients that are good for a business, and there are clients who are not ideal. The terms offered by a business are different for good clients and bad clients. This is, of course, also true in the lending industry. Good clients might get better conditions than bad clients.
While publishing an advertisement of a general offer to the public, the publication is intended to match some kind of typical average offer. In this case, the published APR is called the “representative APR” which is some kind of average. We can assume that good clients would get better conditions; while ‘not so good’ clients would get a loan with worse conditions.
The Math Behind APR
APR formula for compound loans
For those maths whizzes among us who are interested in the details, here are the calculations behind the APR parameter.
The first formula is exactly the same as presented by the FCA in their handbook:
This is a very generalized formula that handles all possible cases. Those where the loan is given bit by bit, and where the repayments are done in non-equal installments. However, most of the time, the loan is given completely at the beginning of the period, and is paid in one or more equal installments. If that is the case, we can simplify the formula to the following:
APR in summary
It is important to note, that from the above formula, we can learn that the effect of using non-compound interest on short term loans, and especially on payday loans is minor. If we take, for example, a payday loan over a period of 20 days, the compound interest applied cannot arrive to a significant difference in comparison to the same loan with non-compound interest applied.
In the example above, when taking a payday loan of 20 days, with a daily interest rate of 0.8%, the loan using compound interest would give a total of 17.27%. The same loan with a non-compound interest rate would be 16%. The compound effect remains small also for short term loans over 2 to 3 months.
However, if we compare these two types of loans after a period of a year, the effect of compound interest on the loan is enormous. The compound interest loan would give a yearly interest of 1732.71%. Contrarily, the loan with non-compound interest will only give us a rate of 292% per year!
It is therefore easy to conclude that the usage of non-compound interest on short term loans protects borrowers from paying insane amounts of interest, especially in the case where he fails to repay the loan on time. This is of course on top of the other safeguards put into place by the FCA.
Remember to make sure you understand the full terms, conditions and fees of any loan before signing the credit agreement. We hope that this straightforward guide has been of use to you. You can find more of our articles on our website, discussing various sectors of the financial industry.