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?
Very simply, APR is a comparative measure to help understand different loans. APR is the interest rate in addition to fees and charges over a whole year as opposed to monthly interest rates. Understanding APR and how it effects a loan is one of the ways that will help you save money.
In this mini guide, we will discuss in depth what APR is and how we can use it in order to identify a better loan deal. Before going into the explanation of APR, we will review some of the basic terms that need to be understood to understand APR better. 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.
Simply, 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, and in most cases the borrower also pays interest as a payment for borrowing money from a lender.
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.
Interest is paid or earned only on the original amount of money.
|Simple Interest on £100|
|If repaying after:||Interest Amount (per month)||Amount to Repay|
Interest is paid or earned on the accumulated interest from the principal. In simple words interest on interest.
|Compound Interest on £100|
|If repaying after:||Interest Amount (per month)||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.
The FCA implemented that lenders can only charge ‘simple (uncompounded)’ interest in order to protect customers 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 customer.
APR is a tad confusing, as lenders can interpret the definitions in different ways. Would the collected money be used to pay back the initial 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.
There is a big difference between APR and interest rates. 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.
APR stands for ‘Annual Percentage Rate’. This means that it is the rate of interest you would pay on a loan over a year, if you would borrow the loan for a full year.
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.
The official FCA 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.
A representative APR is the average APR that a lender has charged customers. It is an average because not all customers will get charged the same amount of interest. The reason for the different charges to customers, is because the higher the risk of lending to a customer, the more the lender will charge and vice versa with a lower risk borrower.
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.
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.
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:
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 pay-day 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!
There is no such thing as borrowing 0% APR loans from a cash lender, unless, of course, you are borrowing money from friends or family or a social fund. In general, lenders will charge you for borrowing cash from them as this is how they make their profit. There are, however, 0% interest credit cards.
Yes, but you might find that lenders will offer you a higher APR than the published representative APR on their website due to the higher lending risk you may pose due to your bad credit history. Consider improving your credit score, to keep payday loan APR costs down.
Although there are apr calculators available online, calculating APR is complicated and often unnecessary. Lenders will calculate their APR on their own and publish it on their website. Use lenders published APR rates to compare different loans in the UK. It’s important to remember that APR only effectively compares compound interest loans. If you want to compare simple interest loans, such as payday loans, the APR parameter is incorrect and insignificant.