There’s a saying that guns don’t kill but people do. Implying that the gun is just the tool, the inanimate object but the person holding it is responsible for their thoughts and actions.
Many credit providers appear to take the same view. It’s not the availability of easy credit that causes debt problems but people with many needs and wants looking for instant gratification. One of the issues I have with that argument is that while there is a general lack of financial education then consumers do not know the full implications of buying on credit or taking out simple, quick payday loans.
One of the main elements is a lack of understanding about the true cost of the borrowing, the bullets in the gun, the APR. The Annual Percentage Rate (APR) is used to provide a guide to repayment costs and provide a benchmark for comparison with other lenders.
In simple terms a loan of £100, or $100 taken out over a year at an APR of 10% would cost £110 ($110) or an additional 10%.
When loans or credit agreements are taken across several years it gets a bit more complicated but the principle is the same.
Factors Affecting APR
Several factors affect the APR at which a person can borrow, these can include:
An individual’s credit rating – the ‘safer’ you are in the credit provider’s eyes the lower APR you can obtain. If you are employed with no record of missing payments and perhaps a homeowner with other credit cards etc. then you will typically be offered better terms than someone without these.
For February 2011 in the UK lenders who advertised their APR rates must show representative rates. They may have a range of terms (prices) but must show figures as a representative example. This prevents people from seeing a rate advertised and assuming that this is a fixed price for every customer.
Secured or Unsecured – if you are borrowing as an individual or for business, if you can offer security or sometimes called collateral then you may receive favourable terms. The lowest APR rates are usually for mortgages which are secured against the value of the property.
Length of term – Banks and other financial companies are in the business of making profits. One of their main methods of doing this is by lending money and charging interest. If you wanted to borrow over 3 years to buy a car for example, they may charge a lower APR than a shorter term loan or overdraft. This means that they will be receiving interest over 3 years albeit at a lower rate.
Why is some APR so high?
Some finance companies and so called payday lenders offer short term loans at very high interest rates, ranging between 800 – 3600%. Their acceptance criteria is generally lower than high street banks for example and so their business model anticipates that a percentage of borrowers will default, or not be able to payback the loan. Customers who do pay their loans back are paying extra to offset those who don’t.
As the name suggests, payday loans are designed to be short term, typically less than 90 days. Therefore the full extent of the high APR figures is not generally considered. Borrowers are typically in urgent need and are looking at a solution to their problems rather than part of a sound financial plan.
Also payday loans will generally be smaller than other borrowing, perhaps limited to £500 or £1000. In this way the customer does not again see the full implications that a high APR brings.
Why should you care about APR?
In many cases it is almost inevitable that people will need to borrow money at some point in their lives. Whether student loans, buying a house, or financing a business. Other borrowing can in my view be more discretionary but society, advertising and other pressures may say different.
When looking at borrowing take a look at the APR and consider whether this is the only or most appropriate form of finance. Will the ‘loan’ be short term or long term and what level of repayment can you comfortably afford. Will this also be true should your circumstances change? Finally look at the overall cost of the borrowing added to the purchase price. A bargain purchase may not seem such a bargain once the full cost of borrowing has been added.
