What are Interest Rates?
The interest rate of payday loans or savings, tells you the rate of interest applied to the saving or borrowing.
Interest is essentially a percentage of your loan or saving that is added on, over a set period of time.
Interest rates can are be calculated across any period. That is, starting from a daily basis to the more common monthly, or annual calculations.
- If you borrow £100 at 5% interest over a month, you will pay back £105 at the end of the month
- If you borrow £100 at 5% ‘annual’ interest, you would pay back £105 at the end of the year
Interest is often calculated as ‘compound’ interest. In this instance, interest is tallied on both the original loan amount, plus any interest added on.
For instance, a 10% annual interest rate (over 2 years) on £100 borrowed would be:
- £110 year one.
- £111 year two. (The extra £1.00 interest added as 10% of the £10 interest in year one)
Please note, the above example is very oversimplified. In reality, it involves far more complex calculations as money is also paid back over the loan term.
What is Representative APR?
If you look at any type of personal finance product, you will see a ‘Representative APR’ detailed.
This figure can (and often does) differ greatly from the interest rate advertised.
First, a Representative APR should be representative of the offer given to (at least) 51% of customers. For example, the majority of customers.
Secondly, the Representative APR should take into account any fees, charges or extra costs associated with the loan or saving.
Finally, a Representative APR calculation must take compound interest into account. It should also use this to provide a more ‘realistic’ cost of borrowing (or saving).
Confusion in the HCSTC (High Cost Short Term Credit) sector is commonplace.
HCSTC refers to any business offerin short-term finance with an interest equal to, or above 100% APR. And also, has a maximum loan term of 12 months.
Payday lenders are some of the most well-known companies in the HCSTC sector.
In the payday lending space, almost every payday loan broker or lender or will advertise interest rates between 292%-1272% APR. By definition, a high cost short term credit loans is anything over 100% APR. This does not mean that all high cost short term loans are necessarily loans bad credit.
As of September 2019, the short term credit space tends to focus on short term loans with APR’s in the hundreds rather than thousands and loans tend to be spread out over 6-12 rather than the 1-3 which was customary in the past. This means that loans are becoming more affordable and also that the face of the payday loan customer is changing.
Why do we always confuse Interest rates with RepARP?
First, to explain the 292% interest rate, you need to understand the various price caps given to the HCSTC by the FCA.
First, there is a 0.8% per day price cap. If you multiply 365 days a year by 0.8% you get 292.
It is also important to understand another important cap. This is where no loan can be more than double the amount borrowed.
Think of this as a 100% interest ‘lifetime cap’
All representative APR calculations need to take ‘compound interest’ into account.
Which brings us to the third point. HCSTC companies are not allowed to use compound interest rates.
When you take all the above into account, RepAPR can be quite misleading and confusing. In this scenario, it isn’t ‘truly representative’ of anything. Because all customers offered a loan, are still protected by the 0.8% per day interest rate.