What does APR mean?

It’s all very well deciding that you need a loan, but when it comes down to it – how on earth do you know whether one loan is better than another? This is where understanding what all those abbreviations mean – like APR – (no – not short for April), is key. The world of finance has a whole language of its own and we won’t pretend, it can hurt your head trying to work it all out – so here goes.

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Loan interest

There’s no such thing as free money (it’s a shame but sadly true). If you take out a loan, you’ll need to pay interest on it – which is essentially the cost of borrowing the money (as well as any arrangement fees a lender may charge.) The interest charged on a loan depends on how much you want to borrow, for how long and also your own credit score may impact the rate you are charged. For example, if you wanted to borrow £1,000 for one year and the interest rate was 5%, you would have to pay back an extra £50 (5% of £1,000) plus £1,000 borrowed – a total of £1,050. So far, so good, right?

What is APR?

The APR is the ‘annual percentage rate’ which is what your borrowing will cost you each year including interest and any other charges automatically (such as an arrangement or admin fee) that you have to pay on top of your basic loan amount. So you could have an interest rate on a loan of 5% but once extra fees have been added, the APR might be more like 8%.

When you’re comparing loans the APR is a good benchmark to help you compare loans rather than the interest rate but make sure that you look at every aspect of the loan.

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What you see is what you get

Not strictly true when it comes to APRs – lenders are only required to tell you about the ‘representative APR’ when they advertise a loan. This is the APR that 51% or more of people will get but that rate may not be available to the other 49% of applicants, for example if the credit provider sets the interest rate based on credit score and you have a poor credit history you may be charged a much higher APR. The lender will have to tell you the actual APR you will be charged before you take out your loan so make sure you check this carefully.

Compound interest

This is where brain ache is likely to set in. So, we know about how interest is calculated, but compound interest works slightly differently in that it’s worked out by charging interest not just on the loan amount, but on the interest as well. In other words, it’s charging interest on your interest.

Compound interest is great if you have a savings account but not so great if you have a loan. Let’s say you had savings of £1000 and earned 5% interest in one year; after 12 months, you’d have gained £50 in interest – a total of £1,050 in your account. But in year two with compound interest, you would accrue interest not just on your capital amount (your initial £1,000) but also on the interest. So you would earn 5% of £1050 which is £52.5, a bit more than your initial £50!

When it comes to loans, compound interest is exaggerated the longer the loan period is – because you’re paying interest over more time. You should always make sure you read the terms and conditions of your loan to avoid any costly surprises.

So what’s AER then?

If your brain hasn’t exploded yet and you want to find out more, then AER is to do with savings. It stands for ‘annual equivalent rate’ and just as APR is a way of comparing loans or credit, the AER is what is used to compare savings accounts.

AER works by assuming you’re going to stash your savings away for a year. The AER is not necessarily the same as a ‘gross interest rate’ which is the flat rate of interest that you’ll get in a savings account. The AER also takes into account any compound interest plus any bonus introductory rates as well; so overall it’s a better reflection of how much interest you’ll accrue over the course of the year.

One thing to look out for with AERs is that you can’t really compare it between savings accounts against ISAs. That’s because the AER on your savings doesn’t take into account any tax you have to pay on your savings (if you earn over £1000 in interest for a basic rate tax payer or £500 for a higher) compared to an ISA which is tax free – just make sure each time you compare you are comparing apples with apples.

Finding a loan

It’s confusing – we know. Which is why we always try and make things as straightforward as possible, because life’s complicated enough without adding in APRs and AERs and compound interest rates. So let us help find you a loan. When it comes to comparing, we’ll make it clear what the APRs are, what you need to pay each month and overall; forget the complicated sums, it’s as simple as 1,2, click and compare

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