Understanding APRs

November 2004
Ray Boulger discusses some of the problems with quoting typical rates

A recent MORI survey commissioned by the Institute of Financial Services found that 80% of people were unable to identify APR as being the “interest rate and other costs of a loan.” This suggests that at their meeting last month, when they criticised the banks for high APRs on credit cards, the Treasury Select Committee should also have had a target closer to home - the umpteen Ministers of Education we have had over many years who have only educated 20% of people in basic financial matters. Another survey suggests only 40% of people understand percentages but I hope whoever calibrated the results of both surveys wasn’t one of the other 60%! As the APR is a percentage it is hardly surprising so few people understand it.

If APRs were better understood it would be more difficult for financial institutions to seduce customers to borrow on very high interest rates. Notwithstanding this, rather than focus their attention on something which only 20% of people understand, the Treasury Select Committee might have been better off spending more time questioning the legality of fees such as late payment charges, typically around £20 - £25, which most people do understand.

Barrister Richard Colbey wrote in the Guardian a few weeks ago that these charges are legally void unless they reflect the loss suffered by the party enforcing them and as such are unlikely to be enforced by the courts. Perhaps it would have been unreasonable to expect MPs on the Treasury Select Committee to have known this - after all they only make the laws!

APRs are very useful with some types of borrowing, but with mortgages they are worse than useless in most cases. When the Consumer Credit Act covered mortgage advertising it was a legal requirement for lenders and brokers to mislead potential borrowers when quoting an interest rate on a product by also quoting an APR. The FSA has made matters worse by prescribing that the new Key Facts Illustration must include a statement saying “the overall cost for comparison is X.X% APR.” On the other hand some aspects of the new financial promotion rules will be helpful to consumers. If a promotion includes the initial mortgage rate it must also include, at least as prominently, all other interest rates applying to that mortgage. This is likely to result in the demise of adverts promoting mortgages with a cheap short term rate, coupled with extended early repayment charges locking the borrower in to a much higher rate for years afterwards.

Moving back to APRs, the main reason the vast majority are grossly misleading is that they are normally based on a 25 year term, whereas the average life of a mortgage is now only 4 - 5 years, although 25 years is still the most common initial term. Another significant problem is that cashbacks must be ignored. One result of this is that two otherwise identical remortgages, one with a free valuation and free legals and the other a refund of valuation fee and a cashback to cover the legal costs, will have different APRs, unless the rounding to a single decimal place eliminates the difference.

A more serious problem from ignoring cashbacks naturally arises with cashback mortgages. Compare client specific APRs for two mortgages with a 10 year term and with an identical SVR. One mortgage has a 10% cashback and the other has a 0.5% discount for 10 years. The APR on the discount mortgage will be 0.5% less than the APR on the cashback mortgage, although even the Treasury bureaucrats who agreed the basis for APR calculations could probably work out that a 10% cashback on day 1 has more value than a total discount of 5% spread over 10 years. Factoring in the discounted cash flow benefit of receiving the cashback up front enhances the benefit further.

Typical APRs must be calculated on the basis of similar mortgages sold by the lender or broker over the previous year. A broker whose typical mortgage was £300,000 on a 70% LTV might have a different APR for the same mortgage from a broker whose typical mortgage was £75,000 at 90% LTV, primarily because of the different percentage impact of fees. The lender could well have yet another different typical APR for the identical mortgage.

Lenders will know what the actual typical life is of their mortgages, in addition to the initial term, although obviously this will vary with the product. However, brokers will only know the typical life of a proportion of their mortgages. Nevertheless, as APRs are meant to be typical, one way of giving them some value would be to calculate them over the typical life of the mortgage being advertised. If the typical life of a 2 year tracker or fix, without any amendment to its original terms, is 3 years an APR calculated over that period, assuming a final payment in month 36 of the outstanding amount and amortising the costs over that period, would have some value.

Meanwhile it remains a legal requirement for authorised firms to mislead potential clients in their financial promotions by quoting an APR calculated on completely fictitious assumptions. This seriously conflicts with the FSA’s requirement for all financial promotions to be “not misleading.” A partial saving grace is that as 80% of people are unable to identify APR as being the “interest rate and other costs of a loan” only 20% of people seeing an advert will be mislead by the APR!

A final thought. If a mortgage adviser has a senior FSA official as a client is it safer to recommend the mortgage which actually offers the best value for that client’s requirements or would it be more prudent to recommend the mortgage which meets the client's requirements with the lowest APR in “the overall cost for comparison” figure in the KFI? After all, what other use is there in having a figure for the "overall cost for comparison” on the KFI! Come to think of it, why not outsource all mortgage advice to an overseas call centre that could email clients a selection of KFIs for mortgages that meet their requirements and tell them the one with the lowest APR must be best!