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Understanding APR & Short Term Loans

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In this article:

Understanding loan rates

When you’re searching for a loan, you should familiarise yourself with how loan rates work before you choose which loan is right for you.

This is especially important if you are applying for a short-term loan, payday loan or if you have a bad credit history, as your APR is likely to be a lot higher than with regular loans.

That is why it is a good idea to shop around, and using a loan comparison site can give you clear insight into what the cost of your loan is likely to be before you commit to applying for one.

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What is APR and how does it work?

APR or Annual Percentage Rate is a tool for measuring the interest rate, including any other charges, applied to a number of financial products such as personal loans, short-term loans, credit cards and hire purchase agreements.

APR is the amount of interest you’ll pay when you borrow money from any of these products. It is calculated following strict guidelines set in the Consumer Credit Act (1974) which all lenders must abide by.

It is vital that you understand APR and the total amount you will be paying back when comparing loans, to make sure you’re making the right decision for your financial needs.

If you, for example, take out a loan of £5,000 at 5% APR repayable over 36 monthly instalments of £149.50, the true cost of your loan will be £5,385.96 including fees.

If, however, you take out a loan of £5,000 at say 6%, but this time you want to pay it over 48 months at £117.06, the true cost of your loan will be £5,618.88 including fees.

Your repayments are the same every month because of how the interest is calculated. When you first take out a loan your repayments will represent the interest in the greater part, and less of the loan balance. As you progress to the end of the loan, your repayments will be the opposite: more balance and less interest.

So, you see, it can be tempting to spread the loan over a longer period of time, especially as the monthly repayments are lower, however, you will pay more in the end.

How is APR calculated?

APR is calculated using a number of variables and it takes into account:

  • The interest rate
  • The frequency this interest is charged – whether it is a daily, weekly, monthly or yearly rate
  • Any initial fees, if applicable – for example, a processing fee if you are using a broker instead of a direct lender
  • Any compulsory charges applied to the loan which are conditional to the agreement of the loan, for example, Payment Protection Insurance or PPI.

How does Representative APR work for short-term loans?

Representative APR is the rate that average customers would receive when applying for a particular short-term loan and it generally relies on general examples.

The clue is in the word ‘Representative’. When you see a short-term loan offer with a Representative APR, it means that 51% of customers on average will receive that rate or below, although not everyone within the 51% will necessarily get the same rate.

The general assumption is that the lender with the lowest Representative APR will give you the best rate, however, when you apply, it’s likely you’ll receive a Personal APR based on your unique circumstances.

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What is the difference between Personal and Representative APR?

A Personal APR is a rate offered based on the customer’s personal circumstances and the amount they wish to borrow over a certain amount of time. This can only be determined once a full application has been submitted and credit checks carried out.

Therefore, a Personal APR is what is offered to you after your financial situation and credit score is taken into account, while a Representative APR is what is generally offered when standard criteria are met by at least 51% of customers applying for the same loan.

With a mortgage, for example, APR remains the same for everyone, because if you don’t meet the bank’s lending criteria you will simply not be approved for the mortgage – personal APR isn’t an option.

However, with short-term loans, you can often be lured in by the Representative APR advertised, but the Personal APR you are offered could be very different, and by this stage, you may feel tempted to take it.

This is why it’s crucial to carry out a loan comparison to make sure you get the absolute best APR and short-term loan terms that you can, in your current situation.

What should you look out for when taking out a short-term loan?

A short-term loan is designed as a temporary funding solution and is generally paid back within months.

Normally they are used for emergencies, such as car repairs or a broken boiler when you do not have any other way of covering this unexpected cost.

There are many types of short-term loans on the market, but most of them would have the same lending criteria to follow:

  • An affordable amount is agreed between the customer and the lender which must declare the interest rate and total amount you are expected to pay back at the end of the agreement.
  • The terms of the repayment are agreed, whether the loan will be paid back in monthly instalments, in the case of a short-term loan, or in full on an agreed date, in the case of a payday loan.
  • A repayment date for your instalments is agreed; generally, it is the date your salary is credited to your account, or close to that.
  • A credit check is carried out to ascertain your credit history and affordability. This is particularly necessary following recent legislation concerning affordability and thorough checks.
  • If your application is successful, your funds will be paid into your account.
  • You begin making repayments on the agreed date, for the agreed amount, until the loan is repaid in full.

Some payday loans and bad credit loans can carry a very high APR rate, so you must be really sure you can afford the repayments and you have found the best solution for your needs.

When looking at the cost of short term or payday loans, particularly those that are for less than 12 months, it would be more beneficial to consider the annual interest rate, the total amount payable and the cost of the credit – these are much easier to understand ways of looking at the true cost of the loan over the APR which will be hugely inflated for shorter-term loans.