What does APR mean?

Misunderstanding APR could have a negative effect on the choices you make when looking for a personal loan, mortgage and other common forms of borrowing. Once you know what APR is, you’ll be better placed to make informed decisions about your finances, because you’ll be able to compare the full cost of different products. This one could save you real money.

• What is APR in simple terms?
• What is representative APR?
• How is APR calculated?
• What is credit card APR?
• How does APR work on a loan?
• How does APR on car loans work?
• How does APR for payday loans work?
• What is EAR for overdrafts?
• What’s the difference between APR and interest rates?
• How do I compare APR?

What is APR in simple terms?

APR stands for Annual Percentage Rate. APR tells you how much it will cost to borrow money over a year as an average and is always shown as a percentage.

APR takes into account the interest you’ll be charged on your loan or credit card, as well as any fees you might be required to pay on top of that. The figure is averaged out to give a yearly rate and designed to help consumers make a direct comparison between different offers, although it’s not the only thing you should consider.

What is representative APR?

Not everyone who applies for a loan will be offered the same APR, so something called ‘representative APR’ is used by lenders to highlight the lowest rates they will offer to 51% of people who are accepted. The representative APR doesn’t take into account the number of applications that are rejected outright by a lender.

NOTE: If you’ve got a bad credit score or no history of borrowing, however, you may be among the 49% of borrowers given a higher APR than the one you see advertised. For this reason, it’s important to know the exact APR (also known as your personal APR) upfront before you apply, and not just the representative one.

Representative APR (RAPR) will not be tailored to your personal circumstances and borrowing history. By finding out your exact APR you’ll be better able to budget for monthly repayments and decide whether the loan is affordable.

How is APR calculated?

All lenders use the same formula to calculate APR; this allows you to make a like-for-like comparison.Essentially, it is:

1. The interest charges plus fees
2. Divided by the loan amount
3. Divided again by the number of days in the loan term
4. Multiplied by the number of days in a year
5. And finally, multiplied again by 100 to show as a percentage

What is credit card APR?

For credit cards, APR is based on what’s known as an ‘assumed credit limit’ of £1,200 (if your application is successful, the credit limit you actually get will depend on your circumstances) and takes for granted that you spend the full £1,200 on the first day and then pay it back in equal, regular instalments over a year without racking up any other debt on it.

The representative APR on credit cards generally assumes you only use the card for purchases. It doesn't take into account different rates and fees which might apply if you use the card in other ways. For example, a balance transfer using an interest balance transfer credit card. Or a cash withdrawal, also known as credit card cash advance.

It also doesn't include any penalties for things like late payments, going over your credit limit or returned payments. Only compulsory charges are included in the representative APR, such as an annual fee or loan arrangement fee.

Note that even if a credit card has a 0% interest period, there’ll still be an APR. Credit cards with zero interest only apply for a limited time. For that reason, you should always try pay off the full balance, if you can, before the interest starts being applied.

Although APR is calculated yearly, it’s added to your bill once a month. Obviously, if you repay your balance in full and on time, there’ll be no interest to pay. Keep doing this, and you won’t have to worry about how high or low your APR is.

When comparing credit cards and APRs, it’s worth considering exactly what type of card you’re looking at. Rewards credit cards will likely have a slightly higher APR than others, but the added benefits (air miles, loyalty points, etc.) can outweigh that for some cardholders. Similarly, you can expect credit-builder credit cards to have high APRs, because they’re aimed specifically at people with a bad credit score.

NOTE: Most credit card APRs are variable, so the interest rate could change depending on the interest rates set by the Bank of England (or Base Rate) and how you use the card. If you don’t make monthly payments on time, for example, your APR might increase.

How does APR work on a loan?

Just as with credit cards, comparing the APR on a loan is a useful way of gauging which one will work out the cheapest for you. For personal loans, APR will vary based on the amount borrowed, the duration of the loan and the fees charged.

It’s worth knowing that some personal loans have higher interest rates than other forms of borrowing, especially if you want to borrow a relatively small amount. Because the interest rate might reduce the more you borrow, you could be tempted to take out a bigger loan than you need. If so, make sure you are confident you can afford to make the loan payments.

Also, some personal loans have variable interest rates, meaning they can go up or down, for example, tracker mortgages. If initial repayments look like they might stretch you financially, try to avoid this type of loan in case they do go up.

How does APR on car loans work?

Whether you're taking out Personal Contract Purchase (PCP), Hire Purchase (HP) or what's referred to as Conditional Purchase finance, all your car finance quotes should include an APR figure - this includes car loans. Leasing is the exception, but purely because there’s no option to buy the car (i.e. it works much like a rental).

What’s worth knowing is that deposit contribution discounts (for new cars this can add up to a significant amount) aren't taken into account when calculating the APR. Basically, this means that if a big deposit contribution is offered, the APR rate shown will be higher than the real premium you're paying to finance the car.

In some cases, the deposit contribution is large enough to outweigh all of the interest. At the very least the discount will effectively cover some of it. As with other types of borrowing, the best way to compare APR is on like-for-like quotes based on the car model, the same type of finance and deposit, mileage allowance and contract length.

How does APR for payday loans work?

Payday loans or short term loans have high APR rates - sometimes over a 1,000%. The reason for this is largely due to the loan term. If you’re only borrowing for a 30-day period, then expressing interest as an annual rate instantly sounds very high. For that reason, loans repayable by instalments over a longer period typically have lower APRs.

And then there’s the fact the formula used by lenders to work out APR is based on loans that charge compound interest (when you pay interest on interest), whereas payday loans charge simple interest.

And so, while APR is still a decent yardstick to compare payday loans, there are other factors to consider, too. For example, the total amount you’ll repay is another good way to compare the cost of the loan.

Of course, a payday loan is an expensive form of borrowing, even for a short period. So, it’s always worth considering payday loan alternatives before thinking of applying.

What is EAR for overdrafts?

As of April 2020 it’s become much easier to compare the cost of borrowing in overdrafts because interest is charged at a single annual interest rate called equivalent annual rate (EAR). Plus, the same interest rate applies for arranged and unarranged overdrafts (previously, banks charged two different rates).

A bit like APR, EAR is the interest you would be charged over a year if your account remained in overdraft (overdrawn or a negative balance). But unlike APR, EAR does not include any fees and charges.

Recent statistics published by MustCompare show that nearly 1 in 5 UK adults go into overdraft every month. Typically, banks and building societies are charging between 15% and 40%. While that may seem manageable, the number of adults dependent on overdrafts to get by each month is reason for concern.

What’s the difference between APR and interest rates?

Many people wrongly believe ‘APR’ and ‘interest rates’ are one and the same thing. What you pay in interest and what you pay overall, however, are two very different things. The APR is almost always higher than the interest rate because it includes other costs associated with borrowing the money.

What makes it even more confusing is that the term ‘interest rate’ is used to talk about money added to a debt, as well as money you earn when you deposit into a savings account. If you’re looking to compare interest on the latter, savings, then it’s not the APR figure you need but rather the AER - Annual Equivalent Rate.

The AER allows you to work out what the total interest that you earn in a year will be, making comparing savings accounts easier. It takes into account the interest you’re paid on the original amount you’ve invested, as well as the interest you make on the interest you earn (what’s known as ‘compound interest’).

For an example of AER in action, let’s say that your bank gives you an AER of 1.5%. This means you’ll earn approximately 1.5% on your savings in one year. If you put £100 in a savings account at the beginning of the year, that means by the end of that year, you’ll earn approximately 1.5% (or £1.50) in total interest. That 1.5% takes into account how much interest you earn when compounding is taken into consideration, as well as how many times a year your investment earns interest.

However, it’s not just adults who can earn interest. Many bank accounts for 16-year-olds and teenagers also have an AER - meaning they, too, can earn interest on deposits. However, as under 18s cannot be offered credit, there is no overdraft or EAR.

How do I compare APR?

Generally speaking, the lower the APR, the cheaper your borrowing will be, but this isn’t always true. Firstly, remember there is a difference between representative APR (what 51% of successful applicants receive) and personal APR, which may be higher depending on your circumstances.

Secondly, note that some charges aren’t included in the APR. You’ll need to find out from the lender exactly what extras there might be, including potentially being hit with arrangement fees (for loans), balance transfer fees (for credit cards), or early redemption fees if you pay a loan off early. Charges for late or missed payments can also have a big impact on how much your loan will cost in total.

You may also be sold insurance to cover repayments if you're unable to earn because of illness or redundancy. If this is added to the loan amount, the interest you will have to pay will increase.

Be aware that when comparing APR, it’s best if you’re looking at similar types of credit and over the same loan term, i.e. the same amount you want to borrow and the same number of years you expect to pay it back. Generally, the more you borrow, the lower the APR rate you’ll see quoted.

Finally, if you suspect you may pay off a loan early, APR comparisons may not be as helpful as you initially think. That’s because an APR calculation assumes that you'll keep the loan for its entire term and, as we said earlier, it is averaged out to give a yearly rate. Read the terms and conditions carefully for a better picture of what the loan will cost if you’re thinking of cutting it short, including those early redemption fees we’ve already mentioned.

Concluding

Here is a quick recap:

• APR, or annual percentage rate, is the cost (interest and fees) to borrow money over a year as an average and is shown as a percentage.
• RAPR, or representative APR, is an advertised rate that at least 51% of borrowers will receive from a lender (at the same or a lower rate). There is no guarantee you’ll get the representative rate.
• EAR, or equivalent annual rate, is the interest you would be charged over a year if your bank account stayed in overdraft (bank balance below zero). EAR does not include any fees and charges.
• AER, or annual equivalent rate, is the amount of interest you could earn over a year on money in a savings account or a similar product.

 If you want to understand other financial terms, check out our Financial Services Jargon Buster.

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