APR is a term that most people are familiar with, yet at the same time, do not fully understand. Officially, it means the Annual Percentage Rate, and represents the annual percentage rate of charge, which includes interest, arrangement fees, and any other compulsory fees or charges. Unofficially, the APR represents the total amount you will pay, as a proportion of the loan outstanding and lets you compare loans that have different fees and charges as well as interest and maturities. It is not perfect, but it’s probably the best solution out there right now.
If you had a 1-year loan for 10% interest and no other fees or charges, then the APR would also be 10%. However, if you had that same loan and added on charges, the APR could look a lot higher. And, again, you could have 5 different 1-year 10% interest loans with all kinds of different APRs due to different fees and charges.
The purpose of APR is to allow you to compare loans against each other. In our above example, all loans may look similar (10% interest, 1 year), but due to different fees and charges they are all very different. APR helps you decide which one is cheapest, and usually the one with the lowest APR is the cheapest – but not always!
APR gets even more confusing when the duration of the loan is less than 1 year. Let’s say you need to borrow £1,000, and only need it for 6 months. You are given two choices:
1) 1 year 10% loan with no fees or charges
2) 6-month 8% loan with no fees or charges
In the first example, your APR is 10%. In the second, the APR will be ~16% (10% * (12/6)) (note, this is not really correct since I am not compounding the interest, but it’s basically right).
So, which loan do you go for? The first one is obviously the best APR. If you take the first loan, you will end up pay £100 in interest to borrow £1k. In the second loan, the one with higher APR, you will pay £80 in interest.
So, in the above case, if you really only need the loan for 6 months you should choose the loan with the higher APR.
It’s also interesting to think of situations where interest and APR differ. What if we have two more loans:
1) £100 6-month 10% loan with no fees or charges
2) £100 6-month 0% loan with £10 charges.
In both of the above instances, if you use the loan fully, you will pay only £10. The APR in option one will be approximately 20%. The APR in option two is 20%.
So, are these two the same? No. There is interest on the first loan meaning if you pay it back earlier you will pay less than £10 and if you pay it back later, you will pay more than £10 as interest charges add up. In the second loan, you will never pay more or less than £10.
What about bank overdrafts? They charge a fee and display a rate but don’t display an APR. Well that will be covered in another post where we will try to calculate an APR for overdrafts. For now, we will just say that overdraft would look a lot more expensive if they did have to calculate an APR.
So, what is one to do with APR? In our opinion, it’s the best starting point. But you cannot look at APR alone. As demonstrated in the above examples, it’s just as important to calculate the cash cost (the number of pounds you actually end up paying!), and also to consider the risks around paying back early or late. If an interest rate seems too low, always check for extra fees or charges. If an APR seems unusually high, make sure you also check the total amount you will pay as maybe the loan is very short.
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