FOOL SCHOOL
APRs Explained

March 7, 2003

Comparing financial products can be a nightmare. One loan, for example, might charge interest at 5% for two years and then 10% for the next three, while another might charge interest at a flat 7% throughout the five years. So which is best?

The Annual Percentage Rate

A partial solution to these problems is the Annual Percentage Rate, or 'APR', that was introduced as part of the Consumer Credit Act. Whenever lenders offer you a loan, they're required to give it and it should always be your first port of call when comparing loans.

The simple(ish) explanation

The APR basically averages out the different interest rates and charges throughout the life of a loan, to give you a single rate. So if you paid that single interest rate (the APR), year in year out, though the life of the loan, then it would work out the same as the quirky product your looking at.

We can go back to the example at the beginning -- the loan repayable over five years with 5% interest charged for the first two years, followed by 10% interest charged for the next three. Averaging out the interest rate over the full five years would give us an APR of about 6.8%. So you'd reckon that was marginally better than the loan that charged 7% flat over the five years (which would have an APR of 7%).

The more complicated explanation

The way the averaging out process works is a slightly weird mathematical process called an ' internal rate of return'.

The correct, and hopelessly complicated, explanation

For the full monty, you'd have to look at how the Consumer Credit Act (and subsequent regulations) says it has to be done. But we don't recommend it!

The Annual Equivalent Rate

Just while we're at it, the flip-side to the APR, where you're saving money and being paid interest instead of borrowing it and paying interest, is called the Annual Equivalent Rate (or AER). Savings products are generally less complex than loans (you're less likely to be promised different fixed rates of interest and there's less in the way of charges), so they're not normally such an issue. The most important thing the AER does is convert a monthly rate of interest into an equivalent as if it was paid annually.

The Problems

As ever, with this sort of thing, there are a few problems caused by trying to squeeze everyone and everything into a 'one-size fits all' interest rate.

A mortgage is the most obvious example. These are typically loans made for a 25 year period, but because of people moving house, or re-mortgaging anyway, most mortgages actually only lasts for about 7 years.

Imagine a mortgage that charges a good cheap rate of interest for five years, but then puts you on a bad rate for the remaining 20 years. The APR will look quite bad because of the 20 bad years outweighing the 5 good ones but if you stopped the mortgage after 7 years (assuming you're able to do so without 'redemption penalties'), then you'll come out a lot better than the APR would suggest. So you have to think about when you're able to end the mortgage without penalties and when you're likely to end it (probably quite soon if you move onto a bad rate and you're not tied in).

The problems get even worse with things like credit cards, because everyone uses them differently. Some will sit there with a £5,000 credit card debt for 10 years, while others will do the Foolish thing and pay the whole lot off each month. Guess who comes off best?! Different credit cards will cost different people more or less for doing different things, even though the quoted APR might be the same. So, after looking at the APR, you need to think about how you're going to use a particular card and what the charges are for that.

The Good Points

The good thing about APRs is that they do at least provide us with a starting point when comparing products. Generally speaking, the really shonky loans that will cost you an arm and a leg, will come up with a horrible looking APR. Also generally speaking, the more reasonable loans will come up with a more reasonable looking APR.

So they're a very good way of separating the wheat from the chaff. But you still need to think hard about what you're likely to do with a particular product and look carefully to see whether the small print makes it suitable.

Find out more in our Personal Loan and Credit Card centres