Blog: APR and the cost of credit
As part of our new series on Funding Affordable Credit, our Head of Strategy Jake Attfield looks at why APR is not always a helpful measure of the value of small sum, short term loans for both borrowers and lenders
Anyone involved in lending or borrowing will be familiar with APR – or the Annual Percentage Rate of Change to give its full name.
APR is the legally recognised mechanism to compare all loans[1]. It’s there to provide a numerical and comparable representation of the cost of credit to the consumer across EU member states. However for short term, small sum loans it’s not always the most appropriate method of considering value for both borrower and lender.
As all lenders know, APR is not the interest rate charged. That’s a different figure. And who better to explain this than Michael Sheen.
APR has three elements:
- the credit amount
- the cost of providing it
- the time over which it is lent
On long term, large sum loans such as mortgages, the balance of these three elements make APR an effective measure. But on a small sum, short term loans the APR figure can be unhelpful and misunderstood. This is because on small sum, short term loans, very small changes on the makeup of the loan will have a significant impact on the cost of loan and the consequences to the borrower.
An example of this when looking at the cost to serve is that APR is generally higher for a new customer than it is for a repeat customer. A combination of factors can drive this higher cost to serve including:
- variable costs of sourcing and onboarding a new customer are higher than when providing a repeat loan to an existing customer
- lending to a new (unknown) customer is often regarded as higher credit risk than lending to a customer who has already repaid a loan
It’s therefore both reasonable and rational for responsible lenders to attempt to recover these additional costs via a higher cost to the consumer. And charge a higher cost for higher-risk loans to compensate for the higher bad debt risk. This means a higher APR.
In the same way, extending or reducing the term of a loan or borrowing different amounts will also significantly affect the APR presented to the borrower. For example, borrowing £200 for a new fridge over six months rather than a year, when the total cost of credit remains the same, would see at least a doubling of the APR. And repaying on a weekly basis instead of monthly can also affect the APR, even when the cost of credit and loan amount are the same.
The higher APRs we see on small sum, short term loans may be necessary to enable responsible lenders to cover their costs. And while offering loans at these higher APRs is a rational business decision for responsible lenders, this can have a negative reputational impact and can also impact their ability to secure lending capital and other investment.
Lots of CDFIs and commercial lenders alike have stopped offering short term, small cash loans, instead offering larger loans. However, for many customers, access to small amounts of credit is valued and valuable. And while it’s not cheap and carries a high APR, for these customers it’s preferable to many legal and illegal alternatives.
At FairAll Finance, we would like to see a new, industry standard measurement method or means of presenting the real cost of credit that works alongside APR. We believe this could help credit providers and consumers see how the value of different products compares, help consumers make better decisions and drive good practice and competition.
[1] EU rules on consumer credit, https://commission.europa.eu/business-economy-euro/financial-services/consumer-finance-and-payments/retail-financial-services/credit/consumer-credit_en