The comparison of borrowing options can be confusing – some lenders quote monthly interest rates while others use quarterly or annual; some advertise low interest payments but add on hefty ‘arrangement’ fees, whilst others charge high interest rates with minimal fees. However, all lenders must show the Annual Percentage Rate (APR), which is calculated in a standardised way across all financial products; APR therefore enables borrowers to make an easy and fair comparison between different loans and credit options.
Annual Percentage Rate (APR)
the Standardised Interest Rate for Borrowing
APR shows the total amount a debt would cost if you borrowed the money for one year
APR is a yearly rate, expressed as a percentage of the original amount borrowed (the principal).
Example:
If you took out a one year loan of £1000 at 7% APR, you would pay back the loan plus £70.
Tip:
Think of APR as how many pence it costs to borrow each pound per year
At 7% APR, it costs 7p for each pound borrowed: 7p x 1000 = £70 a year
If you borrow money for less than a year, you pay less than the annual interest charge.
But the Annual Percentage Rate provides a good standard way of comparing deals.
APR takes into account the interest rate plus any unavoidable costs the borrower has to pay e.g. upfront charges for financing the debt. Charges are spread over the borrowing term and included within the annual rate.
Example:
The quoted interest rate for a loan might be 5% per year but the APR could be 7%, because the arrangement fee and administration charges add the equivalent of another 2% interest.
Some products include special introductory interest rates; if these apply for less than a year, APR takes account of the introductory rate as well as the higher rate once the deal ends, to give a more realistic annual rate.
APR can be a fixed or variable rate.
Generally, for similar length borrowing terms, the lower the APR the cheaper the debt – but always check how much it will cost overall.
Limitations of APR
APR provides the best general comparison, but it does have some limitations that you should be aware of:
Not all charges are included
APR includes upfront financing charges, but these can vary by lender, so always ask exactly what is included in the APR, and what else you might have to pay on top e.g. insurance.
APR does not include avoidable charges, like fees for late repayments or penalties for the early settlement of loans.
Note that additional charges and fees can have a big impact on the overall cost of borrowing!
Find out more:
You might not be offered the advertised APR
Lenders only have to offer their advertised ‘representative’ APR to just over half their customers, but they must quote the rate that will apply to you. The actual rate charged is likely to reflect the amount and duration of your debt, as well as your credit rating and personal circumstances.
APR is not so suitable for comparing short-term borrowing options
APR is an annual calculation, so it is not the best measurement for comparing loans/credit that last less than one year; in this case, APR will always be considerably higher, because the cost cannot be spread over a whole year (as for longer term loans). So for short-term borrowing, it is better to compare how much interest is charged per £100 borrowed, or look at the daily rate of interest.
Effects of compounding – Quoted APR v Effective APR
Lenders often advertise the Quoted APR, which is the simple ‘flat’ annual interest rate that does not take into account the compounding of interest within that year.
Effective APR does take into account the effects of compounding and represents the real rate you would pay for borrowing.
Just be clear which rate is being quoted, so you can compare like with like and understand the overall cost.
Find out more about APR:
Interest Rates Guide – Money Saving Expert
APR AER Fact Sheet – The Guardian
