Interest Rates: APR and AER
The interest rate that you pay on a loan determines the amount at which you are being charged for taking the loan out. There are many different ways in which interest can be charged so sometimes it can be tricky to get your head round it but don’t worry, in this guide we will tell you everything that you need to know about paying interest on a loan that you have taken out.
This guide will give you an in-depth knowledge of the different ways in which interest is charged and also the ways in which it can be different from product to product. If you want to know which banks or building societies offer the best loans for the lowest amounts of interest then one of the best ways to do that is to head over to a price comparison website. Price comparison websites offer people a way to compare a huge variety of different financial products at a few clicks of the mouse. Here at Money Expert, we feel that the best type of decision one of our customers can make is an informed one. That is precisely why we offer a free and impartial price comparison service, which lets you make an informed decision about which financial product is offering you the best value for money. Our price comparison tool allows you to look at a wide range of different offers that are currently on the market and see which one suits your needs the best. It will even let you tailor your search so that you only get results that are relevant to you.
In this guide:
The Cost of Borrowing
The easiest and most accurate way to define what an interest rate is is by simply viewing it as the amount that you are being charged to borrow the money that you are being lent. This means that whatever the rate of interest that you are being charged by your bank or building society, that is how much they are making you pay for the service of lending you the money.
If you have been wondering why you can always see financial products, such as loans, being advertised with a percentage rate next to them, that is because this is how interest tends to be calculated. Interest is calculated as a percentage of whatever the total sum is that you are being lent. This means that if you were to borrow a total of £100 and you were charged 5% interest on that sum, you would need to repay a total of £105 in order to fully pay off the debt.
It gets slightly more confusing when you start talking about loans from banks or building societies because they tend to charge interest on an annual basis. What this means is that when you make your repayments on your loan, you have to pay back a certain amount each month that will then add up to the same amount of interest as you were originally quoted by the lender. If this sounds a bit complicated, don’t worry it’s actually quite straightforward.
Let’s use an example.
This time let’s imagine that you’ve borrowed £10,000 (it gets a bit fiddly with smaller sums) at an annual rate of 10%. This means that the total amount of interest that you will pay will be £1,000. As you are being charged annual interest, you will need to have paid that back by the end of the year, and you will pay back equal sums each month. This means that halfway through the year you will have paid back a total of £500. Makes sense?
So those are the basic things that you need to know about what interest is but it can get a bit more complex in practice…
APR: what does it mean?
Okay so you’ve got the basics down but know we need to start talking about some of the technicalities behind the interest rates that you will see advertised on loans or other credit-based products. The number that you will always see on any credit-based product is known as the APR. How do we know that it will always be there? Because it has to be, according to law.
APR stands for Annual Percentage Rate. It is calculated by taking into account not just interest rates but also any other fees that are necessarily included in taking out the loan. These fees can often be for things like checking your credit rating or simple administrative set up costs. However, having all of these different fees, which will all change from bank to bank or loan to loan, it can become very difficult to work out exactly which bank or building society will actually offer you the best price for lending you the money that you want to borrow. That’s where APR comes in.
The main aim of APR is to do away with some of the confusion that surrounds the various costs that can be associated with taking out a loan. It is intended to serve as an easy measurement that can be used to compare all of the various credit products that are out there on the market at any one given time. Otherwise you may have to do loads and loads of complicated maths just to work out how much the bank or building society will be charging and nobody likes that.
Like many different sectors in the UK, the banking sector has a regulating body that makes sure that everything is running as it should and makes sure that all encompassed organisations are going about their business in the proper manner. The regulator for the financial, banking sector is called the FCA (Financial Conduct Authority). The FCA is one of the organisations which enforces the fact that all credit-based products must have an APR. This is what they save about Annual Percentage Rates:
"APR stands for the Annual Percentage Rate of charge. You can use it to compare different credit and loan offers. The APR takes into account not just the interest on the loan but also other charges you have to pay, for example, any arrangement fee. All lenders have to tell you what their APR is before you sign an agreement. It will vary from lender to lender."
Of course it can be slightly confusing when you look at a loan that is on offer and it has an APR of 13% but an interest rate of only 10% but this is because such a loan would have a number of charges that come with it, which is the equivalent of another 3% worth of interest on the sum that you are borrowing. However, this is truly quite a helpful tool because it allows you to easily compare and contrast that loan with other loans from different lenders.
One thing that you should be very careful with is lenders who speak to you about interest rates in monthly terms when you have correspondence with them. For credit-based products such as credit cards or personal loans, it is unfortunately quite common for this to happen. Whilst the company will have had to have advertised that product with an APR just like everyone else, they no longer have to use that if they need to change the rate that you are paying once you already have credit with them. This means that you could often expect to receive letters from your credit card company informing you of a monthly interest rate rise of 2%, which doesn’t sound too massive at all. However, if you were to look at that in terms of APR it would total a staggering 27%.
Some issues with APR
Whilst APR sounds like a perfect way of comparing different financial products and knowing exactly how much you are going be charged for each one, it actually has quite a few drawbacks.
One of the biggest issues with relying too heavily on APR is the fact that many people often have changing rates on any credit-based product they may have taken out. When this happens, APR can actually make things a lot more complicated than they would have been otherwise. This is mostly clearly demonstrated with mortgages. When you take out a mortgage the APR will be based upon the amount that you will be paying back over the entire term of the mortgage, along with any other fees and additional charges that you may have to pay to your bank or building society. It is this Annual Percentage Rate that you will have seen advertised alongside the mortgage online or magazines.
However, in practice this doesn’t really mean that that is what you will be paying for the entire term of your mortgage. What it actually means is that you will pay back an average of the Annual Percentage Rate that you have seen advertised.
Let’s use an example. Imagine that you had seen a mortgage advertised that offered a rate of 6.6% APR. You could, in theory, take out this mortgage and never ever get charged 6.6% in its entire 25 year term. Instead of getting this sum, you could be charged a lowered rate of 4.5% interest for the first two years of the loan and then be charged a variable rate rate of 6.75% for the rest of it. This would mean that the 6.6% APR would have been the average rate which you would have paid if you kept the same mortgage for the entire 25 years. However, it is very unlikely that this would have been the case because many people switch mortgages a lot in order to keep themselves on a competitive interest rate from banks or building societies.
In fact this is what the founder of MoneySavingExpert, Martin Lewis, had to say about the matter:
Look on any mortgage advert, and loudly and prominently you will see the APR. The regulations state it must be equally as prominent as the biggest other rate. The only problem with this is it’s a meaningless number that bears little resemblance to the amount most people end up paying.
The supposed consumer protection regulation that enforces this display of information just goes to confuse consumers. We need a far more joined up way of doing this.
Another problem with using APR as a guide to how much a mortgage will actually cost you, is the fact that you may not even end up being charged that amount anyway- even as an average! The reason for this is the fact that when banks or building societies advertise their loans or mortgages or credit cards, they normally do so by advertising what is referred to as the “representative” APR. What this means is that not everybody who takes out the financial product will be receiving the level that it advertised. All that is required for a bank or building society to be able to advertise a representative APR is that at least 51% of the people who apply for the given credit-based product will actually be granted that amount. This means that up to 49% of the people who apply for that same product will be receiving a different rates of interest- normally a higher rate. The problem is that you won’t know exactly how much you will be charged until you have applied for the given product and by then it might be too late.
A further problem with using Annual Percentage Rate is the fact that they only ever include the compulsory charges. Whilst the doesn’t sound like a problem at first because you won’t have to pay any of the additional charges, it can actually be used against you by your bank or building society. The way that this can happen is the fact that they often hide charges for things such as PPI (Payment Protection Insurance) as needing to be opted out of. This means that if you’re not careful, you will end up paying for it without realising and you will essentially be paying a higher level of APR. However, because of the fact that this charge is not a compulsory one, your bank or building society were not legally obliged to include it in the advertised Annual Percentage Rate- most likely it would have just been hidden somewhere in the small print of the terms and conditions.
Beware flat interest rates
Whilst we may have just been talking about all the problems with Annual Percentage Rates, it is definitely not the worst type of interest that you can find on a loan. It is often used by places such as car dealerships in an attempt to make it sound like their vehicle finance plans are a lot cheaper than they are in reality, although this is becoming increasingly rare.
With a loan that has a stated Annual Percentage Rate, you are only paying the interest on the outstanding level of debt. This means that if you have a loan that started off being worth £5,000 and offered you interest of 6% APR, you do not pay 6% of £5,000 the whole way through. Instead you pay 6% of whatever it is that you haven’t paid off. This means that with a 6% Annual Percentage Rate loan of £5,000 you would only pay back a total of £800 interest.
However, if the loan that you are looking at doesn’t say that its quoted rate is the Annual Percentage Rate, then chances are that you are looking at a loan that charges a flat interest rate. “Wait,” I hear you say, “flat, that means low, that means good!” Ah but how wrong you are. A loan that charges a flat rate of interest is a loan that will charge you the same amount of interest for the entire duration of the loan term. Whilst that sounds the same as the way in which interest is charged on Annual Percentage Rate loans, these loans do not charge you that percentage on your outstanding balance. Instead, these loans charge you on the total sum that you borrowed right at the beginning of your loan. This means that the total amount that you will pay back by the end of the loan will be significantly higher than it would have been if the loan was offered to you at an annual percentage rate.
For example, if you were to borrow that same £5,000 at a 6% interest rate but on a loan that only offered you a flat rate of interest, you would end up paying back a total of £1,500 by the end of your loan term. What this means is that, even though the loan might initially have sounded very cheap, it eventually ended up costing a lot more. In fact if you put a flat interest rate loan like this into an annual percentage rate, you would end up looking at a loan that cost about 12% APR instead of the 6% that is suggested. This means that you should be extra wary if you are ever offered a sales agreement on a car. Make sure that the interest rate is on there is the annual percentage rate and not a flat rate of interest. It is worth noting that it is illegal for any form of consumer credit to not have the Annual Percentage Rate written on them.
How to find the best loans
If you are looking for a loan or mortgage or credit card, it is highly recommended that you pay a quick visit to a price comparison site. Price comparison sites were made so that consumers can quickly and easily search for the financial products that they are looking for. After typing in exactly what type of loan or mortgage or credit card it is that you are looking for, the price comparison tool will return to you with a list of many different relevant products that are currently being offered on the market today. These price comparison tools allow you to get a good idea for what the market is like and allows you to be much more informed when you are making your decision about which product is right for you, and which product offers you the best value for money.
Here at Money Expert we offer an impartial and free price comparison tool that can provide all of our customers with an extensive summary of a huge array of different credit-based products. We believe that the best way to find yourself the best deal on anything is to shop around first, this means that you need to be able to see what’s on offer. That is precisely why we offer a free and impartial price comparison service, which lets you make an informed decision about which financial product is offering you the best value for money. Our price comparison tool allows you to look at a wide range of different offers that are currently on the market and see which one suits your needs the best. It will even let you tailor your search so that you only get results that are relevant to you.