A Pile of Rubbish? APRs un-explained.

Don't know your APR from your EAR? Well, the Unbanker himself decided it was time for a human-friendly explanation of all the lending acronyms which, he reckoned, would only take a few minutes to write. It has taken 3 days to make sure it's correct, he thinks...

There are all sorts of mad ways of calculating the cost of debt. It seems that every method depends on hiring a private detective, or getting a maths degree, to work it out.

The Unbanker was so astonished that he had to call in his crusty Finance Director, Nigel, (pictured left) to check the smallprint.

Even Nigel , who crunches merrily through numbers like a ferret in a box of cornflakes, is still scratching his head wondering if the Unbanker has finally got it all right. 

Confused? You will be.

Hmm. If that's not hard enough then try this:

This is (no, really, it is!) the helpful formula to let you work out an APR rate! All clear then? No? Are you stupid or what?

Don't worry, even the Unbanker got a bit lost at this point.

So what is an APR actually?

An APR is the Annual Percentage Rate; or in other words what it actually costs over 12 months to borrow money. So, if you borrow ￡100 at 10% interest rate it will cost you ￡10 per year. Easy right?

Ah. Well not quite. That would be too easy to understand. This part is just the "nominal" interest rate.

Then you have to add in something called Compound Interest. When you borrow ￡100 at 1% per month for a year, it immediately starts to attract interest charges, so they can charge you more interest-on-this-interest (and mathematically more interest on that more interest on the interest and so on, like Buzz Lightyear, "to infinity and beyond"!).

Anyhow, an APR adds on more interest on interest. Then the lender will usually chuck in some other fees and charges. And that's your lot. This is what makes it the "Effective APR"! (well, very effective for them anyhow.....).

The result is that a rate of 1% per month, giving a nominal interest rate of 12%, might actually end up being an effective APR of 15% or more. ￡100 at nominal interest of 10% might look like costing ￡10 a year whereas the effective APR is 15%, so it costs you ￡15 a year, which is an increase of 50%!

Overall though the Effective APR is a useful measure to let you know how one complete cost compares to another.

So....what's an AER?

Pass. We won't deal with AER here, but it's pretty much the APR for savers.

Hang on, it says this is a "Representative" APR? (Look out now, Fog ahead)

Well, in theory we have got to a 15% effective APR. OK, great. Can I have that deal please? Ah well no, sorry. Your APR would be 30%.

WHAAT? Yeah, sorry, that's why we said it is a "Representative" APR? Or, just to keep you on your toes, it might also be called it a "Typical" APR.

You see, there's a near even chance that YOU may not be quite "typical" enough. That's because anyone getting an unsecured loan is only marginally (51/49) odds-on to get a loan at the rate advertised. What it means is that they have to ensure that at least (!) 51% of loans go out at the advertised rate.

So what about the other 49%, "un-typical" loans?? Ah well, those other 49% untypical oddballs like you will get another, higher rate! You would have thought the ads should say "lowest potential rate 15% APR", but I guess that would be too easy.

So when you read "Representative" or "Typical" APR remember that it's a bit like saying: "As a lender we promise that typically we will only actually give these rates 51% of the time!!". Not the best start to a relationship, eh?

Ear, ear, what's the APR on an unplanned overdraft?

Ah, the bankers have ring-fenced their special exclusion zone in overdrafts.

Just to make things nice and simple, bankers don't have to apply an APR to overdrafts and unplanned overdrafts, and indeed they have several completely different ways of measuring them. If they charge interest, they call it an EAR (Equivalent Annual Rate).

More like, Oh dEAR.

It all starts rather well. As with unsecured loans, bankers work out the cost of overdrafts as interest and (compound) interest on the interest. OK. Good so far. Looks fair enough too, at about 19.5%.

But then, sneakily, somehow they have managed to persuade the authorities that, unlike loans, whenever they show the cost of overdrafts they DON'T INCLUDE FEES and CHARGES! So, naturally enough, the clever clogs bankers can set an OK looking EAR, and then BOOM!!! In come a load of heavy charges which they list separately. These charges can be up to ￡50 a month PLUS 19.5% interest.

OK then, listen up and get your EAR clear

The closest thing to overdrafts, is the short-term or payday loan. But payday lenders have to advertise a representative APR even for the shortest of loans, far shorter than most overdrafts. So they can look comparatively expensive, when in fact they can well be much cheaper than bank overdrafts.

Meantime the bankers either get away with hiding behind the EAR (which may not include additional fees and charges) or they can simply list simple daily fees that seem cheap but, as you will see below, are not.

Here is one extreme example:

A loan of ￡100 for 20 days from a leading payday lender (yes, them) would cost you ￡10.40, according to their website calculator.

By the Unbanker's pocket calculator, ('cos the bank doesn't offer one. Hmm), the same ￡100, 20-day loan as an unplanned overdraft from a major bank brand would cost you ￡100.

So to be clear:

• to borrow unplanned ￡100 from a leading bank brand for 20 days will cost ￡100
• to borrow ￡100 from a leading payday brand for 20 days will cost ￡10.40.

Quite a difference eh?

But it gets worse: the payday lender has to show their charge as a seemingly staggering 1,509% APR whilst the bank, which is 9x more expensive, can look nice and cheap at ￡5 per day. However, and you should cover your eyes here if you are of a sensitive nature, the corresponding APR for the bank unplanned overdraft on this example is.... over 30,000,000% APR. Yes, that is 30 million % APR. Now that is what I call a little bit extra.

By the way, the same loan, on a planned overdraft basis from the same major bank would still cost just less than double even than the leading payday lender brand, at ￡20 for the 20 days, at 2,687% APR assuming no other charges! (Uncle Nige's laptop melted at this point).

Of course, not all examples will be this extreme, but it is used here to show you how much of a muddle this whole area is, and how, by and large, charges and costs are not clear, and how the game is tilted in the banks' favour, not yours.

Time to unbank?

Our conclusion was that, when you simply want to know what a loan will cost for a period time, why can't that be the measure they all always have to show you?

Eg. "Borrowing ￡100 for 100 days will cost you ￡10".

For comparison purposes, to check you have the best deal against all other forms of borrowing, they should also have to say:

Eg. "￡100 borrowed on this basis for a year will cost ￡150".

It just seems that in the overdraft area especially, it is all an un-standardised mess which makes it really hard to work out how much you actually pay or what fair comparisons are. But, of course, whose interest might that be in, we wondered?

The good news however is that now you no longer need a bank at all. These days you can get a huge choice of loans, often much more cheaply, from other non-bank providers; you can also manage your money from the Unbank of U with your personal U Account. No bankers. No lack of clarity. After all, it's for YOU, not them.

Postcript: anyone who disagrees with the Maths or the explanations above is welcome to explain it better. We checked MoneySaving Expert, and other respectable financial web sites in writing this article. There was very little clarity or agreement! If nothing else it shows that the underlying thesis is absolute: this (complex) area needs greater clarity.