The interest rate of any loan or savings, specifically tells the consumer the rate of interest applied to the saving or borrowing.
Interest is essentially a percentage of the loan or saving that is added on, usually over a set period of time.
Interest rates can be calculated across any period, starting from a daily basis to the more common monthly, or annual calculations.
- If I borrow £100 at 5% interest over a month, I will pay back £105 at the end of the month
- If I borrow £100 at 5% ‘annual’ interest, I would pay back £105 at the end of the year
Interest is often calculated as ‘compound’ interest. In this instance, interest will be calculated 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 vastly oversimplified and in reality involves far more complex calculations as money is also paid back over the loan term.
If you look at any type of personal finance product, you will usually 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 e.g. the majority of customers.
Secondly, the Representative APR should take into account any fees, charges or additional costs associated with the loan or saving.
Finally, a Representative APR calculation must take compound interest into account and 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 offering short-term finance with an interest equal to, or above 100% APR and 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 lender will advertise an interest rate of 292% Apr.
Yet, their representative APR will almost always display 1000%+
Why is this?
First, to explain the 292% interest rate, you need to understand the various price caps the HCSTC sector has been given by the FCA since November 2015.
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, 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 me to the third point, as HCSTC companies are not allowed to use compound interest rates.
When you take all of the above into account, RAPR can actually be quite misleading and confusing to the customer as (in this scenario) it isn’t really ‘truly representative’ of anything as all customers who are offered a loan, are still protected by the 0.8% per day interest rate.