Payday loans and the annual percentage rate or APR

An important concept that just about anyone that has ever come into contact with borrowing money in some shape or form will have come across. We have all seen these 3 letters when it comes to borrowing money and rather like trying to remember those pesky acronyms from school, have struggled to truly understand what the term actually means. Don't worry you are not alone and what sounds simple enough to trot out when asked, is anything but. Want to know more about the bad credit loans that we offer, then visit our questions page.

This guide aims to ask those "this is probably a stupid question but" type questions, such as what APR is, how APR is calculated, why we need it, when it's accurate and sometimes when it is less than accurate. We will attempt to delve into the maths (or math as US English would have us write) and finally see how APR applies to common forms of borrowing from mortgages and credit cards to payday loans.

Definition of APR

APR stands for annual percentage rate and represents the true cost of borrowing as it incorporates both interest and any other associated fees or charges connected to the loan. It annualises this over the year, allowing the borrower or prospective borrower to compare between different financial products from different providers. Put another way, the APR is a "standardised" rate (helpfully expressed as a percentage), incorporating all compulsory fees associated with a loan.

This is from the regulator, the Financial Conduct Authority (FCA):

FCA APR definition

Source: FCA Handbook

Back to school

Angry teacher

Right we know where we are going to get to, but let's start at the beginning shall we? When someone agrees to lend you money it is very common for that person to ask you for a bit more than just returning the sum borrowed. You are now up to speed with the concept of interest. A loan has a set period of time after which it has to be repaid. This is known as the term and can be altered after the borrower has received the money. Interest is connected to the amount of time a borrower has the loan.

Simple or compound interest?

Yes, we know that these terms are coming thick and fast but please keep going! Ok, we've grasped interest is the bit on top to keep the lender happy but there are different types of interest just to make things a little more interesting. Simple interest is when the lender only charges, and continues to charge, their bit on top of the actual amount lent over the life of the loan. Got it? Ok good, now for compound interest. This is when the lender charges interest on the interest that is accruing over the life of the loan. More complex, and to understand we are going to have to dig deeper. Most mortgages use compound interest for example.

Example of simple vs compound interest

Simple interest:

Year 1: £1,000 x 1 year x 10% = £100 in interest

Year 2: £1,100 (£1,000 principal plus £100 accrued interest) x 1 year x 10% = £110 in interest

Total interest: £210

Total of the principal amount plus interest = £1,210

In this scenario, with interest compounded annually, the total amount of interest paid is £210. Now it's important to note that this is a highly-simplified example but it should be enough to demonstrate the difference between the two types of interest.

Work out the APR in your head!

So, we've established what compound interest is and it’s safe to say it's not an easy one to work out the impact over the life of the loan. There is a neat way to back into the APR and work out how much in interest you will end up paying in total. If we told you that you could probably do the calculation in your head you would be quick to scoff but read on and like all great problems, it's easy when you know how. Side point to note that here at 247Moneybox towers we like to show off sometimes in meetings by running this calculation and watching the jaws drop round the table which is what could happen to your friends when you pull this mental trick out the bag.

All hail the Rule of 72

What you have to do is ‎divide 72 by the interest rate to see how long it takes to double. So, take for example, at 12% interest, save £1,000 and you would have £2,000 in 6 years. At 5% interest save £1,000 and it would take approximately fourteen and a half years (simply 72 divided by 5 gives the answer 14.4). This rule of thumb works pretty consistently up to 20%.

Let's see Rule of 72 in action! Right, so the scene is set and your friends are waiting with baited breath after your outrageous claim that you can work out the APR borrowing £80,000 and repaying £200,000 over 6 years. For the sake of this example let us assume no repayment is made during the life of the loan and go on to wow with a simple piece of compound interest:

  • Step 1 - £200k is 2.5 x £80k, therefore in 6 years the amount owed has increased by 2.5 times
  • Step 2 - As it takes 6 years to increase 2.5x, we can say it doubles approximately every 4 and a half years. This is a very important estimate, and it's vital to note that the growth isn't a straight line or linear. Make sure when you estimate you take this into consideration.
  • Step 3 - Apply the Rule of 72, which is to divide 72 by 4.5 giving you 16 (%)
  • Step 4 - Stand back smugly and watch all around you stare agog at your mathematical brilliance. Invite them to use a calculator to check you've crunched the numbers correctly. If they do actually take you up on the calculator bit, the actual answer is 16.4% to 1 decimal place, but they should give you that!

Interest and payday loans

Now that we've established that compound interest means that you will paying back more in interest over the life of the loan, what does this mean for various types of credit products?

For payday loans, the regulator of the industry, the Financial Conduct Authority (FCA), stipulate that lenders can only apply simple interest. This has multiple benefits for the consumer:

  • Pay interest only on amounts borrowed
  • Easier to calculate total amount repayable
  • Avoid debt spirals where it becomes very difficult to repay the actual principal of the loan

In addition, lenders are only allowed to charge up to 0.8% daily interest and borrowers must never repay more than double the principal borrowed. So, if you borrowed £200 you would never have to repay more than £400 no matter how long it took.

The maths of APR

Ok back to school everyone! For those maths bods out there that really want to get into the nitty gritty, we can now delve into the numbers and concepts underpinning the APR calculation. Cue images of the Matrix and Einstein.

The FCA present the following in the Handbook:

APR formula

Source: FCA Handbook

Still here? Good for you, that formula is enough to make anyone duck and run for cover! The above is a generalised formula that covers numerous scenarios. For example, where the loan is drawn down in stages and where the repayments are in non-equal instalments. However, it is much more common for the loan to be fully advanced at the beginning of the period, and is re-paid in one or more equal instalments. If that is the case, the formula can be simplified to:

A simplified version of the APR formula

Source: FCA Handbook

Where S, above, is the present balance of flows; if the aim is to maintain the equivalence of flows, the value will be zero.

Why is the APR for payday loans so high?

We've seen how APR is calculated and what it's conceived for. We can see where it can be very useful for comparing credit products however, we must also consider APR and where it may not be as useful. As we have established, APR is the standardised way for comparing financial products so all the rates of all loans and mortgages must be presented in the form of an APR. When the measure was conceived as a comparison tool, the products it would have to accommodate were long term i.e. the repayments were scheduled to continue for more than a year. As a result, APR is a good method for comparing products like mortgages and / or credit cards.

When comparing payday loans, the APR can be a very confusing measure of interest. Why is this? Prior to the FCA price cap some payday lenders were charging up to 6,000% APR, but what does this actually mean? Why was it the case that some lenders charging the same interest rate had very different APRs?

"When comparing payday loans, the APR can be a very confusing measure of interest"
Click to Tweet

Let's turn to these questions. The APR for payday loans is a large number due to the fact that high APR is calculated at an annual interest rate. An average term of a true, one instalment, payday loan is around 30 days. Therefore, taking a loan which lasts only a few weeks and multiplying it as though you were borrowing for the entire year, results in an APR that's in the thousands.

The APR is a legal requirement for payday loans and lenders must display it. The FCA payday loan regulations stipulate that payday lenders must clearly state the Representative APR on all financial promotions (where triggered, which is another article itself!) and pre-contract communications. This is to ensure that borrowers can make an informed borrowing decision and can, if they so choose, make an easy comparison between different credit products and lenders. We are all about a balanced approach to lending and firmly believe that responsible lending starts with an honest, open and transparent approach to communication with a prospective customer. The saying "it takes two to tango" is also apt when describing responsible borrowing and responsible lending.

How to calculate the Representative APR

The Representative APR refers to the rate of interest that will be granted to at least 51% of successful customers. The Representative APR is likely to vary based on the duration on the loan. See below the APR and representative example for our bad credit loans:

Representatve APR for 247Moneybox

What is the true cost of a payday loan?

A more useful way of calculating the true cost of a payday loan might be to consider how much the lender charges for a standardised sum over a standardised period. So, for example you could look at the cost of borrowing £100 over a period of 28 days. Alternatively, lenders may also state the daily interest charge which is also a standardised measure and allows for a more useful comparison tool. Since 1 Jan 2015, the FCA has capped the cost of a payday loan (and other forms of high cost short term credit) to 0.8% per day.

Cost of an online loan from 247Moneybox

Young couple compare loans

As a direct lender, we offer payday loans from our own balance sheet. Having gone through APR in some detail you will now be in a good position to understand our representative example and representative APR. Hopefully now you will see that the large numbers are not as scary as perhaps it was easy to assume. It would be great if all industry observers took the time to go through a similar process but alas with money lending being such a sensitive topic, there perhaps isn’t the desire. If the above information makes sense, and you would like us to consider a bad credit loan application, then why not apply.

Common APR pitfalls

We have established that the APR is a comparison tool however you must ensure you are comparing apples with apples. Sometimes it can be confusing what fees are included in the APR calculation. This is especially true when it comes to optional fees. For example, you may choose to have same day funding instead of a 3-day transfer. It costs an extra £5 but that might be worth it to you. Did the lender factor in this £5 to their APR calculation? Some might, some might not. Confusing.

When looking at financial promotions, APR can be less than clear. A website might show a loan with an attractive APR. However, you must also consider whether it is realistic whether you can actually get this rate. This is where the representative APR comes in, however, remember that is what 51% of applications can hope to achieve. You might not be one of them.

When you see a loan's APR, it is reasonable to assume that the loan will be paid off over its entire lifetime. For example, the APR on a 30-year mortgage is calculated with the assumption that you’ll keep the loan for 30 years. In practice, the majority of us re-mortgage numerous times in those 30 years! If you pay off a 30-year mortgage after 3 years, the APR will lead you down the wrong road. You'll see lower APRs on loans with high up-front fees and lower interest rates. Unfortunately, you won't be able to spread the up-front costs you pay over the term. If you pay your loan off early, the actual APR is higher than what you see quoted. APR is of most use if you plan to keep the loan for the full term.

Yes and no. Sorry, we know that’s annoying but the confusion is a very common one and one that isn’t totally without merit. The AER or Annual Equivalent Rate is the official rate for savings accounts, and is designed to allow easy comparisons as it's meant to smooth out the variances between accounts. So think of it as being the equivalent of the APR. Why we use AER and APR for saving and borrowing respectively is not 100% clear as it may be confusing to some but at least you now know!