What is APR?
APR is a measure used to show how much the interest on credit will be. It shows it by displaying the amount that you will need to repay in interest on an annual basis. While it’s worth bearing in mind that no measure is perfect (not least because interest rates can change over the lifetime of a loan), APR can be a useful way to compare loans. But while it’s often used, it’s not quite as often explained. The basic idea of APR is that it allows for an easy way to compare loans. By looking at the amount of interest earned on a loan on an annual basis, you can then see which offers the better deal. It’s not flawless, but it’s one of the best measures that are out there.
Why is APR used?
- APR is used to compound interest
Compound interest is an important aspect to credit that not everybody understands. Basically, as a loan goes on, you end up needing to pay interest on the entire amount owed – including any interest already gathered on the loan.
So, if a loan has an amount of interest on an annual charge and you roll it over, you will then need to pay the same amount of interest on the entire amount owed, not just the original loan amount.
For example, if you pay 10% interest on a loan at the end of the year, you’ll then need to pay 10% on the amount outstanding the following year, including the interest that has been gained.
This can mean that it can take longer to pay off a loan than it may appear at first glance. An annual percentage rate takes this into account, allowing you to more accurately measure loans against each other.
- APR is for a consistent amount of time
Annual percentage rates also have the advantage of being for a consistent amount of time. This is important when it comes to loans, as an attractive percentage on a short amount of time may be a worse deal over a longer period of time.
- APR can compare like for like
It’s important to be able to compare like-to-like when it comes to loans and interest rates. A great rate for a short amount of time may not be as great over a longer period. A great rate that is compounded could end up costing significantly more than a larger rate that is not compounded.
This works less well with short-term loans, as very small variations can lead to massive differences in percentage. A difference of a day or two or a percentage of actual interest repaid can mean the difference of hundreds or even thousands of percent of APR.
This is because the APR formula doesn’t work as smoothly with amounts of time that are a lot smaller than a year. They have to be multiplied and compounded, so minor changes make large differences.
Whatever the measure you are using to compare loans, make sure you’re using a consistent measure, otherwise you may as well be comparing apples to oranges.
What are other measures of interest are there?
Shorter term loans may have a monthly interest rate. As above, this is partially because APR can be confusingly high when it’s used for loans that are for a smaller length of time, as the rates need to be multiplied and compounded in order to reach an annual rate.
However, it’s important to remember that loans with a monthly interest rate can continue if you do not pay them back on time, so they can end up being more expensive than they may appear at first. It’s also worth checking whether the interest rate that it shows is the interest includes compound interest or not, as this can make a much bigger difference than normal with shorter time rates.
Flat rates can be deceptive, as they do not tend to include compound interest. As a result, a flat rate can look more attractive than it actually is. The rate is actually on the entire amount outstanding, not just the original loan amount.
It’s worth seeing if there are any other measures of the loan before agreeing to it, so you know what you are applying for. It can still be a useful measure as long as you’re comparing like-to-like. So if you are looking at other flat rates, it’s useful to compare. However, if you’re comparing to an APR, it may appear lower while actually being more expensive overall – sometimes, considerably more expensive as well.
Annual Equivalent Rate (AER)
This isn’t for loans, but you’ll often see it if you’re trying to read about interest. AER stands for the Annual Equivalent Rate. It’s the amount of interest that is earned on savings accounts – it’s basically similar to APR, but with money you’re earning rather than money you’ll need to pay.
Again, as with all other forms of interest, it’s important to compare like-with-like. Savings accounts can also be measured with gross rates which are used for monthly interest. When this is used, interest builds each month on the complete amount saved. So, if you gain interest one month, you’ll gain interest on the interest already earned. Not all accounts do this, so the gross rate may be different to the AER in some cases.
Also, some savings accounts have bonus rates, which are usually for a shorter period of time. If the AER includes this, it can confuse the rates a little bit. It’s always worth taking the extra time to make sure that the rates you are comparing are being shown the same way, otherwise it can be difficult to work out which offers the best deal.
What is ‘Representative APR?
Representative APR is the amount that a company has to show. It’s based on the amount of interest that 51% of their applicants will successfully receive. This does not mean that you are guaranteed to receive a loan with that interest amount, as the rest of the 49% could receive a different rate.
At the same time, the rule is that at least 51% of applicants get a loan at that rate, so it could be that more than 51% have received that rate. However, the people who don’t get that rate most often get a higher rate.
Payday Loans and APR
This can actually be particularly confusing when it comes to payday loans. There are situations where the APR can be significantly higher on a payday loan than on a longer term loan, but actually cost less overall.
The compounded interest point is important with regards to payday loans, especially if you need to roll them over. A big part of the point of payday loans is that they’re not meant to be rolled over – they’re meant to be paid off in one go.
Due to the extremely short nature of the loan, the APR can be enormous. While this is appropriate if you are likely to keep rolling the loan over, so you know the amount of interest you’ll gain, it is worth checking how much you’ll repay in real terms as well, so you can compare like-with-like. With some lenders, tiny differences in time or amount of interest can lead to hundreds of percent in difference on an annual rate.