What is Annual Percentage Rate? APR explained

Cost matters a lot when you’re looking for a credit card or loan. Nobody wants to pay more than they need to, but it’s sometimes hard to understand what interest rates and Annual Percentage Rate (APR) actually mean.

This guide explains what APR is, how it works, and how you can understand the cost of any credit you choose to apply for.

What is APR?

APR stands for Annual Percentage Rate. It’s a way of measuring the cost of borrowing money, combining the interest rate and any other charges that are applied by a lender.

The figure represents how much you’ll pay on an annual basis when borrowing money via a loan, credit card, hire purchase agreement or in some other form. It’s an easy and standardised way to show the cost of borrowing.

Finance Companies calculate APR by using a formula set out in the Consumer Credit Act 1974. All lenders must follow this calculation, which means that it’s easy to compare the cost of borrowing using APR rates.

How does APR work?

APR makes it easier to understand the total cost of borrowing while comparing it to the rates offered by other lenders. It’s expressed as a percentage of the total amount you’ve borrowed. This means that a personal loan with a 10% APR should be cheaper than one with a 12.5% APR – although it’s important to also pay attention to any terms and conditions that may be applied by the finance provider.

APR rates only include compulsory charges, so any extra fees for payment protection or other services may not be taken into account. Similarly, late payment fees and other similar charges are not included when calculating APR rates.

How is APR calculated?

APR is calculated according to a formula set out in the Consumer Credit Act 1974. The calculation takes into account:

• The interest rate applied
• When it is charged (whether daily, weekly, monthly, or yearly)
• Any initial fees charged by the lender (e.g. setup costs)
• Any compulsory charges applied to the loan

APR and compound interest

Compound interest is a widely misunderstood aspect of credit that APR can help with. In simple terms, it means that as time goes on, the interest that accumulates against your loan is added onto the total amount owed from which interest is generated.

This means that you aren’t just paying interest on the amount of money you borrowed, but also on any other interest that has accumulated in the meantime.

APR takes compound interest into account, meaning you can compare the cost of loans over a year.

How to use Annual Percentage Rates?

APR rates can be a good way to compare the cost of borrowing, for instance when choosing between one loan or another.

It’s not an accurate way to calculate what you’ll actually end up paying in most cases, however. This is because credit cards and loans use different repayment structures, and interest is generally calculated on a monthly or even daily basis.

Credit cards are a good example of why APR doesn’t necessarily give a good indication of exactly what you’ll end up paying. If you repay your credit card balance on time and in full each month, you won’t pay any interest whatsoever - regardless of the APR rate.

What do Representative APR and Personal APR mean?

You’ll often see an APR rate described as either representative, typical, or personal.

A representative APR rate is used in advertising and must be the rate applied to at least 51% of borrowers who are accepted for credit. This means that nearly half of the people who were approved for credit were given another rate and potentially had to pay more.

Typical APR is the rate that at least two-thirds of borrowers are offered.

Personal APR is the rate you will actually be given. It could be exactly the same as the representative APR rate, but it could also be higher depending on your circumstances and the individual lender’s eligibility requirements.

APR and short-term loans

It’s important to remember that APR calculates the cost of a loan over the course of a year. When you take out a loan for longer than a year, the cost is added up and divided to give you a yearly average. Similarly, when you take out a loan for less than a year, the cost is multiplied to represent the annual cost.

Short-term loans often have a much higher APR rate than some other forms of credit, but that doesn’t necessarily represent their true cost. This is because they offer fast access to cash which you pay back over a short space of time.

Since payday loans, for example, aren’t designed for long-term use, they may not actually be as expensive as their APR suggests. The annual percentage rate represents how much a loan could cost you over the course of a year, not for the month or two that you’re actually borrowing the money.

How else can you measure interest rates?

Monthly interest

You may also see a monthly interest rate for some short-term loans. This is because APR doesn’t necessarily give a clear indication of how much a loan of less than one year will actually cost since the figures will be multiplied and compounded to reflect an annual cost.

A monthly interest rate can give a more accurate steer when it comes to short-term loans, but only if you pay them back on time. If your loan continues to run beyond a month, interest will continue to accrue and compound – potentially making the cost of your loan significantly higher.

Flat rate interest

Fat rate interest seems like a simple way to understand the cost of a loan, but it can be deceptive. That’s because many flat interest rates do not account for compound interest. In reality, the rate shown doesn’t just apply to the amount you borrow, but to the total outstanding loan amount – including any interest that has accrued.

When looking for a loan, borrowers should be careful to compare like for like. A flat interest rate may appear much lower than APR, but it could turn out to be more expensive overall.

What is a good APR?

What counts as a good rate will depend on your circumstances and the kind of finance you’re applying for. The rate you are offered can depend on a number of factors including your credit history and score, along with how well your circumstances match the lending criteria for a particular financial product.