APR riddles prompt multinational reform effort

By Kate Burgess
Published: August 22 2003 14:54 | Last Updated: August 22 2003 14:54

The annual percentage rate - introduced 30 years ago to help borrowers compare loans to get fairer deals - is likely to be replaced amid concern that it is confusing consumers.

As Sandra Quinn from the Association of Payment Clearing Services (Apacs) puts it: "APRs on their own as a way of comparing products are not useful." Ashleye Sharpe, head of money research for Which?, the Consumers' Association magazine, says bluntly that they "don't work".

The European Union and the UK are searching for simpler and more effective means of calculating APRs as part of a broad shake- up of consumer credit laws.

"There are currently a number of different methods of calculating APRs and the government, as part of the review of the Consumer Credit Act, has been in discussions with industry and consumer groups to simplify calculation methods," says the Trade and Industry department, which oversees credit.

The APR was introduced in 1974 to make consumers' lives easier by obliging companies to show the true cost of a loan on a standardised basis, enabling consumers to compare loans.

It was a good idea at the time, say critics. But since 1974, there has been an explosion in the volume and variety of consumer credit. Many observers think that the APR is long overdue for reform.

It was designed to ensure that consumers could understand the full costs of loans, including extra charges such as administration and acceptance fees and the effect of paying interest on a daily, monthly or annual basis.

But the methods used to calculate APRs are far from simple. Dr Robert Hunt, a maths lecturer and deputy director of Cambridge University's Isaac Newton Institute, says that calculating the APR on a simple credit card loan is "totally impossible" for the man in the street.

Top bankers, including Abbey National's Ian Harley, have also admitted to MPs investigating credit cards that borrowers need advanced maths to work out the best deal.

APRs now have such a low reputation among finance professionals that some organisations will not use them. For example, Moneyfacts, which produces comprehensive data rating most financial products, says it ignored APRs because there is "no straightforward way of working out APRs and no two companies do it the same way".

The Consumers' Association, which doesn't use use APRs to compare loans, says it has worked out that the minimum repayments of an identical debt with the same annual percentage rates can vary by 70 per cent.

"There are two different ways of working out APRs and 11 different ways to calculate interest," says Sharpe. "We'd like to see all companies charging interest in the same way".

One of the government's chief concerns is that rates used to advertise loans are over-complex and misleading because the quality and quantity of information included in advertisements varies widely.

Quoted APRs on credit cards are a good example. Card issuers may advertise a promotional rate; a rate for balance transfers from other cards; a rate for normal purchases; and a rate for cash advances. They also charge a different range of fees for late payment, cash advances and excesses over a limit.

Further complicating the calculations, providers levy interest in any number of ways that may not be reflected in the APR. Some providers start charging on the day of a purchase and others on the date the purchase is recorded in an account. Some give consumers 45 days before they start charging, and others much less.

Much also depends on the way consumers use their cards, says Hunt. The APR has little relevance to someone who pays off his or her balance every month.

Rates on rolling credit and credit cards are the hardest to compare, but APRs quoted on mortgages can be almost as misleading. APRs for mortgages, with all the associated charges and costs, are mostly calculated on the basis of a 25-year mortgage, but on average borrowers repay and switch their mortgages every five years.

"For most borrowers the short-term interest rate and the cost of early repayments are more relevant than the APR," says Hunt.

The best way out of the muddle remains a matter of debate. The Consumers' Association says the answer lies in a total cost calculation giving consumers options on the length of a loan.

But there are plenty of other proposals. Apacs, for example, has proposed that all credit providers should display an "honesty" or "summary" box when advertising loan rates. These boxes would display separately key facts on interest rates, charges and fees in a standard format.

The trade body intends to incorporate its proposals in best practice guidelines early next year. The guidelines would then be adopted and incorporated in the voluntary banking code in early 2005.

The government is also looking hard at enshrining summary boxes in a revised Consumer Credit Act. The DTI is expected to enlarge soon on these proposals and its plans for a simpler way of calculating APRs.

The cross-party Commons Treasury committee is due to take fresh evidence next month, and the DTI is expected to publish a white paper on its proposed reform of the Consumer Credit Act in the autumn.