3.4 Annual Percentage Rate (APR)
You have seen that borrowers have to repay both the principal sum and interest to the lender, and that the interest charge may be fixed, variable or capped. On top of this, there are often extra costs. Some of these costs arise from fees which may have to be paid on obtaining a loan and, under certain circumstances, on repaying the loan before the end of the term. Such extra costs include:
- Arrangement fees paid to the lender: These are usually flat rate, one-off fees and are generally charged when the borrower takes out a fixed rate or capped rate loan, or when remortgaging.
- Intermediary fees: These may be paid when a borrower deals with a broker rather than directly with a lender.
- Early repayment (or ‘prepayment’) fees: These may have to be paid to a lender if a loan is repaid early. The argument used by lenders is that earlier repayment can incur additional costs. In the case of personal loans, early repayment charges mean the lender gets a share of the interest which would have been paid had a borrower kept the loan for the full term.
- Tied insurance: Taking out insurance (for instance, payment protection insurance, life insurance, home insurance) may be required with a loan. In other cases, insurance may be optional, although this is not always made clear to borrowers, who might end up paying for inappropriate policies. The commissions earned on such sales add to the profits made on lending.
Given all these different potential charges, and the different methods of calculating interest, it’s important to have a good means of comparing the total cost of debt on different debt products. Fortunately, in the UK there is a way of ensuring an accurate ‘like for like’ comparison, and of assessing which is most appropriate. This is known as the Annual Percentage Rate (APR) of interest. This accommodates interest and those charges discussed above that are compulsory. It does not include optional charges, such as buildings insurance that is not a required as part of a mortgage package, or contingent charges, such as early repayment fees, that would become payable only in situations that are not applicable to all lenders. The APR also takes into account when the interest and charges have to be paid. The method for calculating the APR is laid down by the Consumer Credit Act 1974, as amended by the Consumer Credit Act 2006. Generally, a low APR means lower costs for the borrower.
This means that APR should be seen as only a guide and not a perfect measure. As mentioned in the previous paragraph, it does not include any costs which might occur that are not a compulsory part of the loan. In 2003, the Parliamentary Treasury Select Committee report into credit and store cards found that there were, in practice, two different precise methods used to calculate the APR, and ‘up to 10 different ways in which charges are calculated, meaning that users of cards with the same APR can be charged different amounts’ (UK Parliament, 2003). The Department of Trade and Industry responded by publishing regulations that tightened up the assumptions that could be used in the calculation of the APR. These difficulties were one of the drivers behind the Consumer Credit Act referred to Section 2.1.