APRs

The annualised percentage rate (APR) is a complex calculation which includes the costs and charges involved in a particular loan as well as the interest rate charged. The length of the loan also affects APRs, with shorter loans having higher APRs since APR is based on a notional 12 month period. Borrowers should not confuse APR with the actual interest rate, and the most important thing to know is the total cost of the credit. APR does not tell a customer how much a loan will cost as the following examples show:

MORTGAGE
Borrow 100,000 over 25 years (300 months)
6.5%APR
Repay 675.21 a month
Total Repaid: 202,563

YOU PAY BACK DOUBLE WHAT YOU BORROWED
The total interest cost is over 100% of what you borrowed

PERSONAL LOAN
Borrow 10,000 over 5 years (60 months)
12%APR
Repay 222.44 a month
Total Repaid: 13,346.40

YOU PAY BACK ONE AND A THIRD TIMES WHAT YOU BORROWED
The total interest cost is over 33% of what you borrowed

UNAUTHORISED BANK OVERDRAFT
Borrow 200 over 1 month (30 days at flat fee of 5 a day)
82,400.5%APR
Repay 350 after 1 month
Total Repaid: 350

YOU PAY BACK ONE AND THREE QUARTERS TIMES WHAT YOU BORROWED
The total interest cost is 75% of what you borrowed

SHORT TERM "PAYDAY" LOAN
Borrow 200 over 1 month
1,355.2%APR
Repay 250 after 1 month
Total Repaid: 250

YOU PAY BACK ONE AND A QUARTER TIMES WHAT YOU BORROWED
The total interest cost is 25% of what you borrowed

PUB LOAN
Borrow 25 over 1 week
5370.6%APR
Repay 25 after 1 week and buy a drink (cost 2)
Total Repaid: 27

YOU PAY BACK ONE AND TWO TWENTY FIFTHS TIMES WHAT YOU BORROWED
The total interest cost is 8% of what you borrowed

The pub loan is not a commercial proposition, just an arrangement between friends. But which of your friends would say: I should be delighted to lend you 25, but I fear I must charge you 5370.6%APR interest!

Some politicians are calling for a ceiling on interest rates. But interest rate caps do not make loans cheaper they simply make many short term loans completely unavailable! From the examples above it is clear that the APR does not tell a consumer the actual price of a loan and, irrespective of the amount of interest, the rate will be higher the shorter the loan period. In the current climate we should not be legislating to force consumers to take longer periods of time to pay off their debts. Where rate caps have been tried in some countries, the net result has been consumer detriment, producing greater financial exclusion and forcing consumers to use inappropriate products with high penalty charges.

In December 2003, the DTIs Consumer Credit White Paper stated: A high APR is not necessarily indicative of an extortionate or high-cost loan. For example, the amount of interest repayable for very short-term loans may appear relatively modest and yet can result in a very high APR.

The Competition Commission report on the home credit industry stated: The APR is a particularly difficult measure to interpret, and may be more so in the context of home credit, where APRs are often very high and not a good basis for comparison of loans. This comment is even more relevant to payday loans, which are of a much shorter duration than most home credit loans.

It is therefore very important that borrowers understand the full cost of credit, rather than simply looking at the APR. Unauthorised overdraft charges can be much higher than taking out a payday loan for a month.