APR
The 1974 Consumer Credit Act (known as the CCA and now amended) aimed to bring “truth in lending” to the attention of the public and to businesses providing credit. This Act first introduced the concept of the APR to the UK, which stands for Annual Percentage Rate. It was meant to be the layman’s version of the IRR. It was designed to be a comparison tool and was calculated on much the same principles as the IRR. The CCA laid down how and when it was to be used when advertising loan products and indeed any credit agreement.
But, until April 2000, the CCA suffered from a number of important weaknesses as far as mortgage business was concerned, the foremost being its incomprehensibility – the rules were complex and the average person didn't really understand it. But at least it forced lenders to quote a figure that took account of fees, costs and their timing as well as sorting out the true interest rate from the various anomalies we discussed earlier. But it also produced some dangerously erroneous results.
The Act previously required lenders to calculate the APR in the same way as the IRR but the method imposed required two critical assumptions: -
1. The interest rate used in the calculation of the payment schedule must be assumed to be fixed throughout the entire term of the loan (even if it isn’t) and must be the same as the initial rate. So if a lender offered a loan at 2% pa nominal for the first year followed by 8% pa for the remaining 24 years, the APR was to be calculated as if the interest rate was only 2% pa fixed for the entire 25 year term! Clearly this makes a total nonsense of today’s mortgage products where early rate discounts are common.
2. The term over which the calculation is made is the full contractual term. In practice, most mortgages last around 6 years before people move house or re-mortgage. Moreover, there can be redemption penalties for stopping a loan early. Without taking into account the expected life of the loan, the APR can produce a misleading result.
The accuracy rules for the APR were also bizarre. One had to “truncate” to one decimal point, not round, so an APR of say 7.69% had to be quoted as 7.6% and not rounded to the more sensible 7.7%. It could also be quoted up to 1% too high but no worse than 0.1% too low.
In fairness to the original drafters of the legislation, the CCA was conceived in a period when PCs and spreadsheets had yet to be invented, and so they attempted to make it easy to calculate by producing sets of tables. Regretfully, both the public and the lenders themselves soon lost faith in the APR because of the examples above. So what started out as an excellent and fair idea and originally billed as “truth in lending”, turned out to be “untruthful” in many cases, and the whole Act ended up giving quite the opposite effect to what was intended, ending up mistrusted as a result.
In reality,
interest rates do vary and loans are repaid early.
The
New APR
In
early 2000, a new definition of the APR was introduced.
The main breakthrough is that the new APR must now take account of any interest
rate changes during the term. This move
rectified the most important anomaly and as a consequence of this one step, we
can now have significantly more confidence in the APR as a comparator for
today’s’ loan products.
The
truncating nonsense has also been removed and normal rounding is in.
One decimal point is considered sufficient but lenders are still
strangely allowed the
same 0.1% tolerance (lee-way) as before for under quoting.
So an accurate rate of 7.44% can still be legally quoted as low as 7.3%.
On a 25 year interest-only mortgage of £50,000, this can be a
“lee-way” of £1,750 overall. Lenders
can also still over-quote by a full 1%. A
7.44% accurate APR could also be quoted legally as 8.4% although why anyone
would want to do this is unclear. Unfortunately, this relaxed attitude over
accuracy is sufficient to camouflage some of the subtleties of many loan products.
It is a pity to define such an intrinsically very accurate methodology,
now easy to calculate, and
then hobble the answer that it produces, thus rendering it as significantly less
useful as an accurate comparison tool.
The Act is
now clearer on what additional charges need to be included by defining the TCC
– the Total Charge for Credit – which states exactly what charges are to be
included with the payments, and what charges need not be included, before
calculating the APR. For example,
if payment protection insurance (PPI) is compulsory, it should be included in the TCC,
but not if PPI is optional.
Comparing TCC’s is not recommended, as it is merely a total to prove the charge inclusions and the total gives no clue on the timing of any payment.
Less
happily, the full loan term must still be quoted regardless of actual loan-life
expectancy. In practise there is little the legislators could do about
this since they cannot predict ones personal choice so at least the method is
consistent. But it can produce erroneous results.
As an
example, take a hypothetical 25 year interest-only mortgage where the interest
rate for Scheme A is 7% pa (with monthly rests) throughout the term, and there
are no additional costs or fees, to keep it simple.
I have used the “Loan Comparator” spreadsheet to produce the
following.
Scheme
A
The
APR over 25 years is 7.2%
The
IRR over 6 years is 7.2%
If the
initial interest rate was 5% pa for 24 months, increasing to 7.5% thereafter
(Scheme B) the following picture emerges: -
Scheme
B
The
APR over 25 years is 7.3%
(higher APR)
The
IRR over 6 years is 6.8%
(lower IRR)
If one
relied on the APR alone, it would tell us that scheme A is cheaper.
But if the borrower was to move in 6 years time, the 6 year IRR is
significantly more favourable with scheme B:
so Scheme B is cheaper for most people.
The APR, while insisting on using the full contractual term, is producing
misleading signals to the prospective borrower.
In short,
one must still look to the IRR for an accurate appraisal, which takes account of
all the relevant factors including the likely product life.
Although the new APR is a lot better than the old, it is still not
accurate enough for a proper comparison. The
IRR remains the paramount tool.