COMMENT
How To Spot Bogus Interest Rates

Before joining the Fool last year, I worked for various banks and insurance companies. During my long years on the "dark side", I discovered a few sneaky tricks that very few members of the public pay attention to, or are even aware of. These little ruses occur throughout personal finance, including insurance, investing, banking, borrowing and saving. But it's in the world of borrowing where many of the worst dodges are pulled. Here are three to watch out for:

1. Typical APRs (Annual Percentage Rates)

Until the Nineties, most lenders would offer the same bog-standard interest rate to applicants for credit cards and personal loans. However, improved computing power led to the introduction of "rating for risk", where lenders offer you a personalised interest rate based on your own individual credit score. This quickly took off, because it allowed banks to offer their best rates to valued customers, plus rake in more money from "riskier" lower-income customers.

As individual rating took off, lenders started to use it to manipulate the Best Buy tables. Lenders would quote ultra-low "typical APRs" that were anything but typical. In other words, only a minority of borrowers would get this headline rate, with most borrowers paying more. Inevitably, the government decided to crack down on this devious practice. These days, an advertised typical APR must be offered to at least two-thirds of new borrowers (66%). Read more in The Real Meaning Of 'Typical APR'.

2. The hidden cost of insurance

I'm going to illustrate this point by looking at a typical personal loan out there today. A personal loan of £5,000 over three years from NatWest would cost you £153.05 a month, a total of 36 x 153.05 = £5,509.80. The APR for this loan is 6.6%.

However, let's suppose that you decide to take out NatWest's payment protection insurance, which covers your repayments against accident, sickness and involuntary unemployment, plus pays off your loan if you die. Monthly repayments with Loan Protector Insurance come to £176.47, with a Total Amount Repayable (TAR) of 36 x £176.47 = £6,352.92.

So, an unprotected loan costs you £509.80 in interest, with an APR of 6.6%. The extra charges on the protected loan come to £1,352.92, which is £843.12 more. So, the APR for the protected loan should be far higher, right? Wrong!

The industry cunningly sweet-talked the regulators and lawmakers to exclude "optional" insurance from the calculations for APRs. Thus, a protected loan may cost you thousands of pounds more, but the APR is the same as that for an unprotected. The big scandal here is that this loophole allows lenders to charge a fortune for PPI, safe in the knowledge that borrowers see the low APR and think that they've got a great rate! As in the above example, the cost of PPI can be several times the total interest bill, but it's hidden away "below the line".

Sadly, roughly seven out of ten borrowers are conned into buying this massively overpriced protection. Profit margins on this product exceed 80%. In other words, about a fifth of the above premiums will end up in the claims "pot" – the lender pockets almost all of the rest, with the insurer getting the crumbs from the table. In total, lenders are making about £4 billion a year of risk-free profit from PPI on mortgages, loans and cards.

3. APRs can be manipulated

Essentially, an APR reflects two things: the interest bill that you pay, plus a factor for the time over which you can repay your money. In other words, it's an expression of interest rates over time. And it's time that enables lenders to trick you into thinking that you're paying less interest than you believe.

For example, let's say you take out a "buy now, pay later" loan – one which has, say, a three-month pause (or "holiday") before your monthly repayments begin. (With most loans, you make your first repayment one month after you draw down your loan).

Because, when compared to conventional loans, you wait an extra two months before making your first repayment, your interest bill is higher on a loan with a three-month repayment holiday. So, the APR will be higher, correct? Wrong again! Because you are, in effect, taking out a loan over 38 months, rather than 36 months, you are given more time to repay this loan. Hence, this brings down the APR, making it look as attractive as (or even better than) an ordinary loan. (Something similar happens with Personal Contract Purchase deals, a type of deferred-payment motor finance product.)

In summary, when you go looking for a loan or credit card, don't be fooled by the APR. Check the Total Amount Repayable or "charge for credit" to see exactly how big your interest bill will be. And expect lenders to use high-pressure sales techniques to sell payment protection insurance, which you should give the elbow every time!

More: It's time to find a better Credit Card, Personal Loan and Mortgage.