Understanding APR

Understanding APR - Man Looking At Laptop

We have all heard of APR but very few of us actually know what it is, let alone what it’s worth.

Which is rather scary when a lot of our financial decisions can be made on it.  Then add to the mix that there is a difference in the formula for European APR and American APR, and it gets even more confusing.

So for this article we will be discussing European APR only.

The best way to introduce the concept of APR is through an example:
On a night out my friend Katie lends me £20. When I pay her back a week later I buy her a mocha at Starbucks (£3) to thank her. On the basis of APR, Katie charged me 143,000% APR. This is why it is quite a tricky concept to apply to understanding how much short term loans actually cost you.

It’s not hard to see why 43% of 18-24 year olds have no grasp of the APR on their financial products. But we would like to change that.

What is APR?

APR stands for Annual Percentage Rate. This percentage rate measures the annual charge of a loan, comprising of the yearly interest payable on the loan plus any other applicable charges.

Why not just use interest rates?

Understanding APR - Iphone & Mac Book

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When a borrower is trying to compare different loans, they find themselves facing a number of varying details in terms of fees and charges, as well as the interest rates.

These details make it hard to quickly and easily see which loan option is the cheapest for them, so the idea of the APR is to create a standard way of comparing the relative cost of the loans.

The APR is calculated to include both the cost of borrowing and any associated compulsory fees, which allows for a more accurate comparison between loan options

What does ‘representative’ APR mean?

Representative APR means at least 51% of accepted applicants will be given this rate. This is used to give you an idea of a standard offer.

Why is the APR so high?

Understanding APR - Increasing Graph

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The big issue that leads to misunderstanding APR is when people think the APR is describing how much the loan is going to cost them – but this isn’t the case.

The APR is the cost if you repaid the loan in a year, which is not the cost that short term borrowers would ever pay. Short term loans are intended to be repaid within 41 days, and you will never pay back more than the initial value of the loan in your interest payments, thanks to guidelines set in place by the Financial Conduct Authority.

This is what makes it difficult to interpret a very high APR on a short term loan. The actual cost of the loan depends on the borrowing length as much as the rate – the shorter the loan, the cheaper it will be.

The Takeaway

Borrowers will find APR useful for comparing loans, and finding the cheapest rate on their financial products – but it will not tell them how much the loan will really cost them.

This is why it is important that loan companies are completely upfront about how much you will need to pay back depending on your loan value and borrowing length.

If you find yourself borrowing money regularly, you should speak to a debt advice service such as StepChange who will be able to give you free advice on how to regain control of your finances.

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