Did you know that lenders can manipulate interest rates to make them appear lower? Here are three tricks of the credit trade.
Before joining the Fool at the start of 2003 , I worked for a string of insurance companies and banks.
During my fifteen 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 applicants for credit cards and personal loans would be given the same bog-standard interest rate. However, technological advances led to the development of "individual 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 the majority of borrowers paying higher rates. Eventually, 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 (67%). Read more in The Real Meaning Of 'Typical APR'.
2. The hidden cost of protection
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 add "Loan Protector", NatWest's payment protection insurance, which covers your repayments against accident, sickness and involuntary unemployment, plus pays off your loan if you die or suffer a critical illness. Monthly repayments with Loan Protector cover 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 reason why not is that banks cunningly sweet-talked the government and regulators into excluding "optional" insurance from the APR calculations. Thus, a protected loan may cost you thousands of pounds more, but the APR is the same as that for an uninsured loan. 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, about seven out of ten borrowers are conned into buying this massively over-priced 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", with the lender and insurer pocketing the rest. In total, lenders are making about £4 billion a year of risk-free profit from PPI sold alongside mortgages, loans and cards. It's easy money from mug punters!
3. APRs can be manipulated
Essentially, an APR reflects two things: your interest bill, plus a factor for the time over which you can repay your money. In other words, it's an expression of interest rate and time to repay. And it's time that enables lenders to trick you into thinking that you're paying less interest than you think.
With most personal loans, you make your first repayment one month after you draw down your loan. However, let's assume that you take out a funky "buy now, pay later" loan one which has, say, a three-month pause (or "holiday") before your monthly repayments begin.
Because you wait an extra two months before making your first repayment, your interest bill will be higher for a "three-month repayment holiday" loan. So, the APR will be higher, correct? Wrong again! Because, in effect, you have a loan over 38 months, rather than 36 months, you repay this loan over a longer period. 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 credit, 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 ingnore every time!
More: Find a better credit card, personal loan and mortgage.
A version of this article was originally published in December 2004.
