An explanation of the Annual Percentage Rate (APR)
Why do we need a rate of charge at all?
We live in a complex world, and face many different choices for the products and services which we buy. To make decisions on which to buy, we may use a variety of different aspects, such as
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price |
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quality |
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expected life |
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seller's name and reputation. |
Buying credit is no different, whether you're borrowing money to buy goods or services, or just taking out a loan so you can pay off previous debts. But it is harder to work out the cost of credit than many other services because there can be different repayments at different times. So, if we are to be able to compare the costs of credit between different offers, we need a measure to take account of all of them.
The history
The need for a measure for the cost of credit has long been recognised. Legislation such as the
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Pawnbroking Acts (dealing with facilities allowing you to a deposit a valuable item at a pawnbroker in return for a short term loan) |
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Moneylenders Acts (dealing with money loans to borrowers), and |
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Hire Purchase Acts (dealing with agreements to supply goods on credit) |
all contained requirements for a specific rate of charge to be quoted in agreements, which was a tremendous help if you wanted to compare lots of credit agreements of the same type, but absolutely no good if you wanted to compare the costs of credit between different types of facility because each Act laid down different rules.
In 1968, the then UK Government set up the Crowther Commission to look into the credit market, and their report was published in 1971, leading to a new Act, the Consumer Credit Act 1974, which took over responsibility for the whole industry.
The new legislation created a new rate of charge, the APR (strictly the Annual Percentage Rate of the Total Charge for Credit).
What is the APR?
The APR is a measure of the cost of each credit agreement, taking into account all the charges made under the agreement. It enables you to compare the cost of each deal and work out which is the best value for you. So you can compare one hire purchase agreement with another However, you should not attempt to compare a mortgage with a credit card deal. Each one provides different terms, so you should not expect to compare the two.
How is the APR obtained?
The new law created the idea of the Present Value. For every loan made, there are going to be one or more repayments or other charges, each made at a particular time. The Present Value of each sum is the value of that future payment as at the date the loan is made.
Except where a credit deal is "interest free", the total of future payments will always be more than the amount borrowed, taking into account the lender's risks such as default or loss of income from investing the loan money (and the need to make a profit!).
The Present Value Rule says that, where the amount of an individual future payment is £ A , and this is paid t years from the date of the loan, then the Present Value of that payment is P at a rate of charge of r where
Very few agreements will have a single repayment. For most loans, there will be many payments and charges, so there will be lots of Present Values P1, P2, P3 ....... Pn . These will need to be summed together to balance the amount originally borrowed. The value of r which satisfies that equation is termed the Annual Percentage Rate or APR.
As an example, consider a loan of £100, repayable by three monthly instalments of £33, and where the lender charges a £5 fee at the date of the loan to cover his administration costs. r has to be calculated from the following equation, where four Present Values are put equal to the amount borrowed:
which can be solved for r to give a value of 28.2 for the APR (the law allows for the APR to be given to one decimal place).
One other comment concerns credit cards and similar offers, where the charge is made monthly as a percentage of the balance outstanding. Assumptions are made to allow for the APR to be calculated.
For most circumstances, it is easier to use a computer program to obtain the APR. The one used by most enforcement bodies (Trading Standards and the Office of Fair Trading), as well as by many lenders, is maintained on this website and you can download it by clicking here.
Notes prepared by Bob Imrie © 15 December 2005