The History
The need for a measure for the cost of credit has long been recognised. Legislation such as the
Pawnbroking Acts (dealing with facilities allowing you to deposit a valuable item at a pawnbroker in return for a short term loan)
Moneylenders Acts (dealing with money loans to borrowers)
Hire Purchase Acts (dealing with aggreements to supply goods on credit)
Reputation and Name of Seller
all contained requirements for a specific rate of charge to be quoted in agreements, which was a tremendous help if you wanted to compare lots of credit agreements of the same type, but absolutely no good if you wanted to compare the cost of credit between different types of facility because each Act laid down different rules.
In 1968, the then UK Government set up the Crowther Commission to look into the credit market, and their report was published in 1971, leading to a new Act, the Consumer Credit Act 1974, which took over responsibility for the whole industry.
The new legislation created a new rate of charge, the APR (strictly the Annual Percentage Rate of the Total Charge for Credit)
What is the APR?
The APR is a measure of the cost of each credit agreement, taking into account all the charges made under the agreement. It enables you to compare the cost of each deal and work out which is the best value for you. So you can compare one hire purchase agreement with another. However, you should not attempt to compare a mortgage with a credit card deal. Each one provides different terms, so you should not expect to compare the two.
How is the APR obtained?
The new law created the idea of the Present Value. For every loan made, there are going tto be one or more repayments or other charges, each made at a particular time. The Present Value of each sum is the value of that future payment as at the date the loan is made.
Except where a credit deal is "interest free", the total of the future payments will always be more than the amount borrowed, taking into account the lender's risks such as default or loss of income from investing the loan money ( and the need to make a profit!)
The Present Value Rule says that, where the amount of an individual future payment is £A , and this is paid t years from the date of the loan then the Present Value of that payment is P at a rate of charge of r where
Very few agreements will have a single repayment. For most loans, there will be many payments and charges, so there will be lots of Present Values P1, P2, P3 .......Pn These will need to be summed together to balance the amount originally borrowed. The value of r which satisfies the equation is termed the Annual Percentage Rate or APR.
As an example, consider a loan of £100, repayable by six monthly instalments of £18, r has to be calculated from the following equation, where six Present Values are put equal to the amount borrowed:
which can be solved for r to give a value of 30.5 for the APR (the law allows for the APR to be given to one decimal place).
One other comment concerns credit cards and similar offers, where the charge is made monthly as a percentage of the balance outstanding. Assumptions are made to allow for the APR to be calculated.
For most circumstances, it is easier to use a computer program to obtain the APR.
