What is APR

What is APR (annual percentage rate) and how is it calculated?

Our client asked us – ‘Further to the figures provided, I am trying to understand how the APR comes to 5.2%, given the underlying rate of 3.79%.  I appreciate that the APR will take into account the fees etc, but the ones set out in Section 8 don’t seem enough to give rise to such a difference. ‘

In light of this query we thought it was about time we added some detail on APR to our web site.

Why APR?

The FCA (Financial Conduct Authority) are interested in putting borrowers in a position where they can compare loan offerings easily. Their ‘rules relating to financial promotions of qualifying credit and disclosure’ set out what credit providers need to include in promotional material (advertisements).

These rules apply to figures provided by mortgage Lenders or Intermediaries to borrowers as an illustration of the ‘key facts’ of a mortgage product.

Since lending products will tend to have an initial rates and fees before switching to a longer term rate, it makes sense to have a simple figure that enables the borrower to compare two products – that figure is the APR (annual percentage rate).  That is the theory, but how does it work in practice?

How is APR (annual percentage rate) calculated?

The rules for calculating APR figures are set out in the FSA MCOB rules 10.1 and are as below.
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It doesn’t look very simple does it? Why is this?

This formula is put together by actuaries. In simple terms, an actuary is an individual who was simply too hot at maths at school to be anything else. Armed with Oxbridge educations, actuaries are employed by the banking and insurance industries to use complex mathematical formulae to work out risk, cost and profit.

What is APR in your world?

Unless you are an actuary we suggest you do not concern yourself with the calculations or fine detail. Having said this, you may wish to understand what is included and excluded in an APR calculation.

The APR looks at the total charge for credit over the period of a contract against the amount of borrowing. It is then expressed as a percentage and rounded up or down to one decimal point – e.g. 5.2%

In order to calculate an APR a number of assumptions have to be made. Some of these assumptions are relatively minor such as assuming all payments are made in full and on time.

The two biggest assumptions given the current market are:

  • That the client will stay will the same lender on the same product until the end of the term.
  • That the Lenders variable rate will not change during the term of the loan.

On a 20 year mortgage with an initial fixed term of two years followed by 18 years on standard variable rate, the APR can bear no relation to the initial rate.

What is the reality for APR as a useful measure?

If your intention is to take a mortgage product for 20 or 25 years, never move home, never change product, and rely on standard variable rates not moving, APR is an useful way of comparing two mortgage products.

In reality of course this does not happen.

When a borrower approaches a mortgage broker or lender they are looking for the best rate they can get right now. They can expect to have some change in their circumstances in the medium term and often today’s mortgage product is a compromise as underwriting considerations mean they cannot normally obtain the lowest rates on the market.

A first time buyer on a 90% loan to value mortgage product today may well be moving home within five years. This means looking for higher lending with a more substantial deposit.

A second time purchaser today may well be downscaling before the end of their mortgage term as their children leave the nest.

How APR can change

Below are the key details from a mortgage we arranged for a client with Halifax in 2007. The client had a modest deposit of 10% and underwriting considerations made Halifax a suitable fit as Lender.

Of course 2007 was a different world from today, take note of the APR in section 5 – ‘The overall cost for comparison is 7.3% APR.

Although the initial fixed rate is 5.34% the main driver for the annual percentage rate is the Halifax Variable Rate at the time, quoted at 7.50% (section 4).

In this case the client was looking at 26 months on the fixed rate paying £2,420 per month followed by 214 months (just under 18 years) paying £2,831 per month. This of course assumed the client stayed with the property and the product, and nothing else changed.
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So what actually did happen?

By the time our client came off of his fixed rate period in September 2009, the Halifax Standard Variable rate had plummeted to 2.50%.

Rather than paying £2,831 per month, our client found himself with a payment closer to £1,350 per month – £1,500 less than the original assumption.

Whereas our client would have entered the mortgage contract expecting to re-mortgage in month 27 to avoid a 7.50% rate, a re-mortgage became the last thing on his mind as his payment dropped by over £1,000 a month.

Where did this leave the APR on this mortgage?

If rates stay as they are for the next 15 years we would expect the annual percentage rate on this contract to calculate close to 2.8% (under two fifths of the original estimated figure).
Of course, rates won’t in all likelihood stay as they are for the next 15 years – predicting the APR is a dangerous business.

What can we do that is practical?

Most mortgage brokers take a more practical approach by focusing on the lowest cost for the client including fees over the initial rate period (in this case 26 months). The revert rate (standard variable rate) can be a factor if two products are close in initial cost, but paying more today to possibly save later is not attractive to the borrower.

Better to find the best rate today and then repeat the exercise in a few years. With Lenders continuing to offer attractive rates and benefits on re-mortgage products this continues to be the practical approach.

There is no doubt that APR is a useful measure on a short term lending arrangements where assumptions can be accurate such as on credit cards and personal loans. When looking at twenty or twenty five year mortgage contracts they are less effective.

Changes in your world adjust your needs and your mortgage needs to adapt with it.

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