How does APR work? – Your questions answered

Posted by Andrew Brown in Personal Finance on 30 August 2019

APR stands for Annual Percentage Rate and is a standard measure that allows you to compare the total cost of credit from different lenders.

APR is a combination of interest payable in the first year of a credit facility together with the interest equivalent of any annual fees.

You’ll most likely encounter APR when comparing or applying for credit cards, loans or a mortgage.

The APR you’ll be offered by some lenders will be determined by your Credit Rating. This is called ‘rating for risk’. If you have a poor Credit Rating, the APR will be much higher than if you have a good Credit Rating.

It’s always a good idea to check your Credit Report before you apply for credit, to make sure there are no errors and that all is as you expect it to be, so you get the credit and the APR you deserve.

How does APR work?

Any quoted APR figure reflects the total cost of credit you’ll have to pay to the lender in year 1 for the amount you’ve borrowed. This is the key point to remember.

Let’s look at a real-world example to demonstrate how APR works. Say you’re applying for a personal loan of £10,000. During your search, you see an advert for a loan with a fixed APR of 10%. In this instance, a £10,000 loan with 10% fixed APR requires paying back an extra £1,000 over the first year.

APR also takes into account any special deals that are specific to the credit being applied for. For example, with a credit card, you may get an introductory interest-free period. This means that if you pay the minimum payments on the card, no interest is payable during the interest-free period. The APR calculation will take the interest-free period into account but be wary that this will hide the higher interest rate that will apply in year 2 when no interest-free period applies.

Is lower APR always better?

Generally, a lower APR figure means you’ll pay less interest on what you borrow, reducing the costs of credit. But be aware that APR relates only to the cost of credit in year 1.

There are many specific variations and deals on credit packages. The concept of APR is to give you an easy benchmark to help compare the total cost of credit in different packages. It is a simple year 1 measure, so if you are borrowing for longer than one year, make sure you look at the likely costs in subsequent years. There are unlikely to be any introductory discounts but on the other hand there are unlikely to be any recurring fees for most types of credit. If there is a large fee payable in year 1 (as may be the case with mortgages), then you need also to look at the actual underlying interest rate that applies for the rest of the mortgage term.

It’s always important to borrow no more than you can afford to sensibly repay each month. Even if you secure a low APR deal, this doesn’t give you a licence to get £1000s of credit and spend to your heart’s content. It’s still vital to budget your repayments effectively.

The amount of time you take to pay back credit and the size of the repayments you make can also affect the overall cost of credit for the entire life of the credit facility, in particular for a mortgage. A typical mortgage requires the same monthly payment over 20-30 years. At the beginning, most of the repayments go towards the interest being charged, with a tiny amount of capital being repaid. Near the end of the mortgage term, most of the repayments go towards the capital, with a much smaller amount of interest being payable. If you can afford to make even small additional payments on a mortgage, these reduce the capital amount outstanding more quickly, which can have a surprising impact on the term of the mortgage. In many cases it will be repaid years earlier than originally planned.

Whatever type of credit you obtain, if you are meeting the minimum monthly payments, your Credit Rating will be strengthened with every month that passes. Be aware though that if you only pay the minimum payments required on a credit card, this extends the time needed to clear the balance substantially, as a result of compound interest.

Can APR be negotiated?

Unless you are dealing face to face, usually not.

If you are, then when comparing deals for loans, mortgages, car finance and other sizeable credit agreements, it can sometimes be beneficial to try to negotiate a lower interest rate, or a lower fee. With large-scale credit products like these, the smallest of rate savings can have a significant impact on the total cost of credit.

This is particularly true if credit is advertised with a Representative APR, because you might not be charged the quoted rate. Representative APR means 51% of customers must receive this rate, but other customers (usually those with less than average Credit Ratings) are likely to be charged a much higher rate.

Quickfire APR Q&A

What’s the difference between variable APR and fixed APR?

Variable APR means that lenders could and probably will change the underlying interest rate at any time during the term of the credit agreement. This could be a positive or negative, depending on market conditions. Fixed APR is as it sounds. The underlying interest rate is guaranteed to stay the same until the credit agreement ends.

What does 0% on purchases mean?

For credit cards, this is shorthand for interest-free on purchases made with the card for a specified period. It does not apply to cash advances made on the card, nor to balance transfers. Although this may sound great over the short term, the credit card issuer may counteract this with higher interest rates in the future. Again, be aware of the full, long-term picture.

Is APR the same from every lender?

They are usually very different.

APRs make it easier to evaluate credit packages as they all use the same formula to work out the total cost of credit in year 1 and then convert that back to the equivalent interest rate. It is vital though, to read and understand the terms and conditions of all credit products, as these can differ significantly.

Hopefully this has answered many of the questions you might have had about APR and how it affects the credit you’re considering.

As mentioned, the APR you’ll be offered will depend on your Credit Rating when lenders ‘rate for risk’. This is why it is advisable to check your Credit Report beforehand to make sure there are no errors, no surprises and nothing in the way to stop you from getting the credit you deserve.

checkmyfile offers the only multi-agency Credit Report in the UK, enabling you to see data from all four Credit Reference Agencies in one, easy-to-compare format. It’s free for 30 days and then £14.99 a month if you don’t cancel, which you can do at any time online, or via phone or email.

Check your Multi Agency Credit Report before the PPI deadline

The PPI deadline is at 11.59pm on Thursday 29 August. After this point, you can no longer submit applications to reclaim any PPI you are owed from lenders. If you’ve not done it, the time is now to check whether you are owed money. If you start your PPI application before the deadline, it’s still possible to reclaim what you’re owed.

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