APR - Annual Percentage Rate
Understanding Annual Percentage Rate - APR
• APR Explained
As consumers we are all very 'rate conscious' and constantly made aware of the great high street bank rates. Many of them are 'headline' deals that are not actually accessible to a huge number of those who apply but is it vitally important we focus on the APR? Looking at what we are actually paying back and paying per month is surely more important?
• What is APR
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.
• What is a loan?
• Let’s start by explaining what a loan is:
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 sum 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 sum of the interest is £10, and the sum we would need to return is £100 + £10, which gives us £110.
• Compound interest loans vs non-compound interest loans
The majority of the loan market works with compound interest loans. Explaining the meaning of this is easier done by using an example: A loan is borrowed for £100 and the interest rate is 10% per month. It is very easy to see that after the first month, the value of the loan is £110 (£100 + £10). In this scenario, what would happen by the second month? The calculation would be 10% of the new balance (£110). This gives us interest of £11 and the total value of the loan is now £121 (£110 + £11).
Now let’s compare it to a ‘non compound’ loan. The first month’s calculation is the same. 10% interest on £100 gives the value of £110. The difference starts taking effect by the second month. In a ‘non compound’ loan, the 10% is always calculated on the original £100. This gives us the same amount of interest as in the first month, which is £10 and the total value of the loan is now £120.
The difference seems to be small for a two-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.
According to new FCA regulations, all loans given in the ‘high cost short term’ market after 02/01/2015 must be ‘non compound’ loans. This is in order to protect clients from falling into the ‘compound interest’ trap. Furthermore, if the customer pays the loan in several installments, 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
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. Responsible lenders in the UK can provide only loans with simple interest charges. As well, the use of rollovers has been limited, and a cap was introduced to the overall charges allows.
The APR is still a tad confusing as lenders can interpret the definitions in different ways, related to the allocation of collected money. Would the collected money be used for covering the capital or the interest? 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.
• Understanding the APR term
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.
We can put this into perspective by comparing this parameter to an everyday example: You can think of it as the same idea as putting the amount of calories per 100 grams on food products. Once this parameter exists, it is very easy to compare different types of food, no matter what the size of the package is.
The official definition of APR is: “This 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.
• APR Calculations
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 that 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.
• Representative APR
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
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:
• Conclusion
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.