You see APRs all over the place, when it comes to financial products like payday loans or car finance. Banks and lenders have it plastered across web pages and adverts. But what actually is an APR in simple terms? And more importantly, what does an APR help us to understand?
An annual percentage rate (APR) is a measure that’s used to make it easier to understand how much borrowing money will cost. An APR shows the total amount in interest and standard fees that will be charged for a loan over a whole year. APRs are different to monthly interest rates or interest rates that are displayed for other periods of time.
Understanding APRs and how they tell you how much a loan will cost could save you money.
Having APRs on display for different loan options makes things clearer. With standard fees and other costs of borrowing all included in an APR, alongside the interest rate, it’s easier to see what the actual cost of borrowing money will be. They also make it easier to compare different loans that are on offer because they allow for a direct price comparison between two different loan offers.
In this mini guide, we’ll discuss what APRs are, what goes into calculating one and how you can use them to find a better loan deal.
Before discussing APRs in depth, we’ll review some basic terms that need to be understood first. If you’ve already read about loans and interest rates in one of our other guides, or you know about them anyway, you’re welcome to skip this section and go straight to finding out about APRs.
Let’s start by explaining what loans and interest are:
Put simply, 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 has to return the same sum back to the first party. In most cases, the borrower also makes an interest payment to the lender in return for borrowing money.
The amount that a person borrows in the first place when they take out a loan is called the ‘principal’. Interest is a fee that is charged on top of this when the money is repaid. Usually, interest is expressed as a percentage of the principal. This percentage is then charged according to how long the person borrows money. The borrower and the lender will agree what the interest rate will be when a loan is first taken out.
There are many ways to calculate an interest rate. The most common way is to charge a percentage of the original loan amount for a specific period of time. An interest rate could be 10% per month, for example. If this rate is charged for a £100 loan, the amount paid in interest after one month will be £10. If the loan is repaid in full after a month, the amount to pay back will be £100 + £10, which is £110.
As well as paying interest, sometimes you also get interest yourself! If you put money in a savings account, your bank will pay you interest for keeping it there. Great!
With a simple interest rate, interest is only paid on the original amount of money that was borrowed (the principal).
|Simple interest of 10% per month on £100|
|If repaying after:||Interest amount (per month)||Amount to repay|
Interest is paid on the principal amount as well as the interest itself as it’s accrued over time. In other words, you pay interest on your interest as well.
|Compound interest of 10% per month on £100|
|If repaying after:||Interest amount (per month)||Amount to repay|
The cost difference between simple and compound interest is relatively small for a five month loan. However, as the number of the months increases, the difference becomes a lot bigger. After a year, for example, the value of the example compound loan would be £313. In contrast, the value of the same loan built on ‘non compound’ interest, would only be £220. We can now see that the difference is much more significant for this longer period of time.
Payday loans used to be a very expensive way to borrow money. There were some unscrupulous payday loan lenders around, and they used to charge high interest rates and high fees to their customers. Some customers would get stuck in a debt spiral that was hard to escape from.
Within the last 10 years, the FCA has brought in rules that have made the payday loans industry much safer for everyone. Payday loans are still expensive and should only be used in an emergency, but the new rules make them much less likely to harm people financially. Nowadays, payday lenders must not:
There is an important difference between APRs and interest rates. APRs include additional fees that you will be charged on top of the interest rate. As such, they give a more complete and transparent view of the cost of borrowing. If you take a loan in the UK in which the lender charges fees on top of the interest rate, the price of these will be included in the APR.
APR stands for ‘annual percentage rate’. It is the total amount you will pay for taking a loan for one year expressed as a percentage of the amount you will borrow.
An APR for a £1,000 loan could be advertised as 56%, for example. If you borrowed £1,000 with this APR, after a year, you would pay back £156 in total.
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”.
APRs are primarily used as a comparison tool for financial products. If you want to compare online loans, for example, you can look at the APRs that are on offer to get a quick view of what they cost compared to one another.
APRs clear up confusion and stop things being tricky. If loans are offered with interest rates for varying periods of time and fees are calculated separately to the interest rate, it can be difficult to compare two different loan offers. With an APR, though, you can directly compare one loan to another because they offer an identical comparison of the pricing structure.
Representative APRs are used when lenders can’t actually give the same APR to everyone for a particular loan offer. This usually happens when they need to adjust the interest rate for a loan according to the creditworthiness of the person who applies for it. Customers with a poor credit score are often charged more for taking out credit. This is unfortunate, but it just happens because of the way lending money works. Statistically, lenders take a bigger risk with customers with a low credit score, so they charge more.
In order to advertise an APR as representative, a lender must offer that rate or better to at least 51% of their customers. Not all customers will actually be charged the rate that is advertised. Obviously, up to 49% won’t get that rate. APRs are still useful, though, because they do give us a good indication of what kind of rate a lender is likely to offer.
Calculating an APR is simple. If you see a loan offered, you can calculate the APR as long as you know:
Here’s the formula you then need to calculate the APR:
Let’s say you see a loan offered for two years with a simple annual interest rate of 15%, and a fee of 2.5% for taking out the loan. The loan amount offered is £2,000.
Put those figures into the equation above:
The APR is 16.25%.
Luckily, you won’t need to calculate the APR for any loans you see offered because UK lenders are required to display the APR alongside any loan they offer.
It’s not worth looking for a 0% APR loan from a commercial loan provider. Lenders all charge interest and fees because they need to stay in business. If they didn’t, there wouldn’t be any reason for them to offer loans at all! Loans that are offered with 0% APR often come with high fees for violating certain terms, and these catch people out. These fees can actually make these loans very expensive, and they should be avoided.
You might be able to borrow money from friends or family or a social fund without paying interest instead. 0% interest credit cards are another possibility, although 0% interest is only offered for a limited time with these cards, and people often end up spending a lot of money to borrow with them.
If you’ve got a bad credit score, you’re likely to find that lenders offer you a higher APR. If a loan has a representative APR published, for example, you might find that you’re offered an APR that’s higher than this. This is because having a low credit score raises the risk for the lender. Whenever a lender takes more of a risk, they charge more money. Consider improving your credit score to keep payday loan APR costs down.
You don’t need to calculate an APR yourself. Lenders are required to calculate the APR for you and to publish it when they offer a loan. Just look for the APR that is advertised with a loan when you’re looking to take one out.