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How is annual percentage rate calculated?

Annual percentage rate calculations

The Annual Percentage Rate (APR) enables you to compare the costs of different loans.

Mandatory use of the APR was introduced in the UK in the Consumer Credit Act of 1974, which said that the APR must be the most prominent rate or charge published in marketing or other material for all regulated loans

APR is given as a percentage. This is the annual cost you will pay for your loan in percentage terms.

As well as the percentage rate, the lender must also give you details such as how long the period of repayments will last for, and often you will have to make payments.

In practice it may be more complicated because certain costs may or may not be included in the APR.

This is ironic given that the APR was specifically meant to simplify the loans business by making charges transparent.

How is the annual percentage rate calculated?

There are many different ways lenders can quote the cost of loan.

Most of us appreciate we need to pay an interest rate on debt, but the cost from what seems to be the same interest rate can vary depending on when exactly you’re required to make payments, for instance.

There are also often fees associated with borrowing money, which any given bank or other lender may or may not decide to highlight in its rate.

These fees include:

  • Admin fees
  • Mortgage insurance fees
  • Special discounts
  • Survey fees
  • And many more!

Whether a particular lender includes these fees in the interest rate it quotes you or not can have a big impact on the attractiveness of the loan.

The idea of the APR then is to make it harder for banks to mislead us, and easier for us to judge which of two or more loans is the best, by bringing these charges into one single rate.

Here in the UK, fees relating to the ‘total charge for credit’ must be included in the APR, even including charges such as those levvied for payment protection insurance and brokerage fees.

However some fees are excluded, such as certain bank transfer fees when one account is linked to another, or charges for missed or late payments.

The only way to be certain of what’s included in an APR calculation when comparing two loans is to read the small print, and also to download official documentation on APR calculation from the Office of Fair Trading.

Wikipedia also has a big article going into detail about APRs, but keep in mind that the treatment varies in different countries around the world.

Is APR the end of the story?

Not exactly.

For instance, two loans may have the same APR, but one could be charging you interest annually, and the other on a monthly basis. Most people would find the latter more manageable.

I also think it’s important to trust a company you’re dealing with as much when you’re borrowing money as when you’re looking for somewhere safe for your savings.

I wouldn’t take a loan with a company I’d never heard of – even if it was quoting the lowest APR – without more research into its background.

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