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Tuesday, July 23, 2013

Understanding APR: Everything you need to know

APR may rise if insurance premiums are included in its calculation
APRs differ between secured and unsecured loans

By Barry Davis

Lenders advertise their lending products by their typical APR (Annual Percentage Rating).  The typical APR for a particular lender is the interest rate that they offer at least 66.6% of their customers.

How does APR affect my loan search?

Comparing APR on loan products is traditionally seen as a good way to compare lenders.  However, comparing like-for-like products according to APR is difficult because there are so many influencing factors that make up the rate that you, as a borrower, will be offered. Typical APRs offered for unsecured loans and secured loans will be different; when comparing loans based on APR you cannot compare secured with unsecured loans as the APRs do not correlate. 

When you apply for an unsecured loan with a lender, the APR offered to you will depend on a number of factors.  The most important thing is your personal history of borrowing and credit rating.  This is closely assessed by potential lenders as an indication of the risk associated with lending to you.  If your credit rating is high, you may be offered a very competitive APR close to, or even lower than, the advertised typical APR.  However, if your credit score is less than perfect you may find that you only qualify for much higher interest rates, or may be refused altogether, especially when applying for unsecured loans.  This is because if your credit history is poor you present a higher level of risk to the lender, and this risk will be offset with a higher interest rate. 

If you apply for a secured loan, your personal credit rating is less of an influencing factor on APR, as you are providing collateral for the loan to reduce the risk on the part of the lender.  This is why many borrowers with poor credit scores find their best chance of finding an affordable loan is through a secured loan. 

Financial lenders want to retain their low typical APR because this is the first and foremost way that they are compared with their competitors.  In order for them to be able to advertise their APR as, say, 6.9%, they must offer this rate to two thirds of their customers.  If very few people actually qualify for this rate due to imperfect credit ratings, instead of offering higher interest rates and compromising their low typical APR, large quantities of applications will be declined.  In fact, our research shows that over 85% of unsecured loan applications will be declined for this reason.  For this reason, if your credit rating is less than perfect, your best chance of securing an unsecured loan may be to apply to lenders whose typical APR is slightly higher than the most competitive rates, because the lending criteria regarding potential borrowers may not be so stringent. 

What to keep in mind about APR when searching for a loan

Some important things to keep in mind when comparing loan products based on APR include:
  • Consider the loan length you are being offered.  APR is figured annually, so the longer the loan length, the higher total loan cost you will pay.  Generally the best option is to repay the loan as quickly as possible, but shorter loan terms often equals a higher APR than the typical advertised rate.

  • Is the APR fixed or variable?  Most unsecured loans are offered as fixed rate loans, allowing you to control your budget as your repayments remain fixed for the duration of the loan.  Often secured loans are variable rate, following changes in the Bank of England base rate.  This allows you to take advantage of any interest rate drops during the loan term, but also means that your repayments will rise if the base rate goes up during the life of the loan.

  • Check carefully for any conditions associated with the loan.  Some financial institutions may offer a low introductory APR that then rises after a set time.  It is important to check what your total loan cost will be overall, as it may rise to a very high rate after the introductory period and you may find it cheaper to go with a slightly higher APR from the start in the interests of keeping your total loan cost as low as possible.

  • Always investigate charges for early settlement of the loan.  Some lenders offer special loan rates for flexible repayment products, so that the loan can be repaid early, and regular overpayments are able to be made.  These typically run at a higher APR; loans with low APR may often charge expensive fees for these options, so if these options are important to you, you may be better off going with a higher APR.

  • Some lenders offer optional payment breaks during the loan term, which can affect the APR offered.  If the chance to take payment holidays is important to you, loan products offering very low APRs may not include this option.  Also check if there are compulsory payment breaks at the start of the loan; this will add to your total loan cost as interest is usually charged from the start of the loan. 

  • Check out any insurance premiums included with the loan as whether or not they are included may alter the APR offered to you.

About the author: Barry Davis writes for Your Insurance Quote, a personal finance products comparison service. Some of the articles covered on his site are saving money guides covering topics such as insurance and loans.

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