What exactly is APR?
Hi guys, we did briefly cover this area earlier on in our news feed. However, some of our frequent blog readers have asked for a more detailed article on this topic. So, here you go!
You’ve heard the phrase thrown around countless times, whether you’ve been actively applying for credit or even just seeing the promotional pamphlets pasted to bus stops or those annoying TV ads. Let’s be honest though – most of us don’t really understand what APR is.
Let’s start by looking at the acronym itself: Annual Percentage Rate. That seems relatively straightforward – so why is it, that when we pay our loans back, the interest we pay can be drastically different to the advertised amount?
Well, when you look closely at those ads and pamphlets, you’ll notice that most of them state a ‘representative’ APR, which only complicates the matter further.
Representative APR is the advertised amount or rate that MUST be offered to at least 51% of customers who apply for a financial product. But where does that leave the remaining 49%?
Provided at least 51% of applicants receive the advertised APR, a lender can offer individuals a different APR – this might be a higher rate than advertised, but it may also be lower!
Some people might take out a loan based on a representative APR and find that they pay less, due to an optimal interest rate, as well as reducing the balance, and subsequently the interest repayments – this is why it’s important to really read your terms and conditions.
Interest on a payment is the ‘extra’ amount you pay, and this is how lenders make their money. The interest and APR are not the same – in fact, they can often be quite different.
Your interest represents the total additional percentage you’ll pay on top of the initial loan amount, whereas the APR will tell you an approximate total figure you’ll end up paying over the course of a year, based on an approximate monthly repayment.
The main difference here is that the representative APR will also consider any and all fees that will be applied to your credit – the interest rate is only applicable to the loaned amount, so will not accurately detail things like transaction or application fees.
Why is a Representative APR Needed?
APR is important because it allows banks and lenders to advertise to a larger target market!
When you apply for any kind of credit, your credit history is taken into consideration. This is how a bank will work out what credit they can offer you, and at what rate.
The problem is that everyone has different circumstances, meaning they will be eligible for potentially different rates on the same product. As a bank can’t individually pre-approve and advertise to everybody, they must use a representative APR to calculate a visual example.
How is it calculated?
Guidelines determine that a company should work out it’s representative APR by using previous examples of business from similar products, such as a bank loan, payday loan, or a bad credit loan. The products used should be recent, ideally within the last 12 months.
As previously stated, for an APR to be acceptable to the FCA: the representative APR must “The representative APR you state in your advert should not be less than the APR paid by at least 66% of consumers on the list.”
What about loans shorter than a year?
Not all loans will cover the whole year – it’s increasingly common for the recipients of borrowed funds to pay off the total balance within a year or less!
Furthermore, with the rise of independent lenders, short term loans are increasingly common. So how does representative APR affect this type of credit?
In short – the representative APR is more of a guideline, or hypothetical situation. It symbolises the total amount you’ll end up paying IF you were to pay the balance back within a year.
In cases like this, you can generally work out the total amount you’ll pay by dividing the length of the loan by 12, to get the approximate monthly repayment, and multiplying it by the term of your loan.
Representative APR is undoubtedly an interesting concept – a confusing one, but an interesting one nonetheless. Here’s a helpful extract found from USwitch:
“If you borrow £1,000 on a credit card with a 12% APR, over the course of a year it will cost you £120 (if you pay nothing back).”
As you will be making monthly payments, reducing the balance, and in turn the interest payments, you WILL pay back less than the representative APR amount.
Representative APR and financial products:
APR’s vary massively from product to product – as will your actual interest rate. The more ‘high-risk’ a loan is, the higher the representative APR will be.
The risk factor is determined by how likely a lender is to receive their money back – as they will be making a risky investment in someone with poor credit or no credit, the higher APR and interest rate will justify the loan to the lender – think high risk, high reward.
High risk products include things like:
Bad Credit loans
No credit check loans
That is why these products cost more than traditional bank loans or peer-to-peer loans.
Okay, but what’s the point?
The reason that financial services need to display their representative APR along with the interest rate is because it gives you, the consumer, a better idea of how much you’ll actually pay over a year, including fees.
This makes it much easier for you to compare different products, and find out what you could be saving with different lenders.
Hopefully, this guide has helped to unravel what exactly representative APR is, and how it affects you and lending.
A rule of thumb when applying for a loan is to base your calculations on the representative APR, as it will give you a more accurate repayment figure over the course of the year than the interest rate alone will be. You should also use the APR to compare rates between loans – it is the most tried and tested way to see how much you could save!
Representative APR at it’s core simply represents what the annual repayment is most likely to be!