subject: Why Do Short-term Loans Have A High Apr? [print this page] Annual Percentage Rates (APR's) are used in the Consumer Credit Act as a means of comparing the total cost for credit of a variety of loan and credit facilities. The method of calculation is carefully specified in the Act and there is little room for deviation or expression on documentation or advertising.
When the Consumer Credit Act was introduced in 1974 the financial markets were a lot more straightforward than they are today. Consumers had limited choices for borrowing and these ranged from mortgages (usually variable rate repayment or interest only options) to personal loans and credit cards.
As the lending markets expanded through the 1950 and 1960's many lenders began to charge extortionate rates of interest or fees that confounded consumers. As consumer backlash grew, the government of the day brought in a completely revised way of managing the credit industry and encapsulated the principles in the Consumer Credit Act 1974. This still underpins the way finance is marketed and sold today as well as the forms of documentation used and the cooling off period permitted for customers to cancel.
But the simple days of the 1970's did not really envisage the multitude of complex lending products, such as payday loans, available in the market in the 21st century. That said, the principles behind the Annual Percentage Rate are sound but can look odd where the ending period is for less than 12 months! Under the Consumer Credit legislation, all borrowing products have to calculate and show an Annual Percentage Rate which includes any and all charges for credit equivalent to if the borrowing were for a one year period.
So where the borrowing is for less than a year what looks like a reasonable charge for credit of, say, 20 for 80 of borrowing over 25 days equates to many thousands of percent APR. This is akin to saying that there are fifteen 25 day periods in a year meaning that the cost of credit is 15 X 20 or 300 for borrowing 80! Clearly that is not the case but a quirk of the way in which the formula for APR works. The fact that it is not possible to borrow the 80 for a year is irrelevant.
So, the APR can be a useful guide to the overall cost of credit but is must be viewed in context of the actual charges incurred when looking at short term loans or borrowing for less than a year. As a guide, it is fine for longer term lending and is a good comparator. But where the lending is for only a few tens of days the APR can look horrifically high. Always check the total amount that has to be repaid in addition to the APR.
Since the APR is a defined formulaic approach you can be assured that all the necessary elements have been included. So using the APR to compare products of a similar duration can be helpful. But to do this you must make sure that the products have the same lending terms since even a few days difference can change the APR quite considerably.
