Five ways the 'typical APR' misleads us

We look at some ways that advertised interest rates are not always anything like what they appear to be.

On the whole, the annual percentage rate or APR that you see in big text in adverts is a reasonable guide to the real cost of a credit card, mortgage or loan. If the APR on one debt is higher than another, it usually means it's truly more expensive. However, this simplified system can contain errors, it can be abused by lenders, and borrowers themselves are prone to misusing it.

1. Premium cards

With premium credit cards you pay an annual fee for a credit card with benefits, such as extra insurances and breakdown cover. However, due to strict rules on how the APR must be calculated, it can be misleading.

This is not the fault of the card provider, which probably wishes it could calculate it another way. I demonstrated in Watch out for lenders' tricks that the advertised APR on these cards can be three times higher than it really is.

That said, for many people, premium credit cards are not worth the fee, because the individual products you want can often be bought more cheaply and at better quality separately. Before getting such a card, do some research to ensure that you're one of those for which they are suitable and cost-effective, perhaps by asking a question through our Q&A tool.

2. Borrower error

I hope most lovemoney.com readers realise that an APR of 16.9% is an extremely expensive debt, but it's clear from reading the messages and stories of thousands of debtors that many are oblivious to that fact.

It doesn't matter if you pay off the debt in six months, you're still paying the same rate of 16.9% APR, it's just that you're not paying for as long. Such high interest rates can make it harder to repay, especially if you have an emergency and have little spare monthly income.

Even a low APR can have a massive cost if you fail to take into account the length of the loan. If a lender suggests you take a longer loan at a lower interest rate to make it easier to meet monthly repayments, you could end up being a lot worse off in the end, because you're paying interest for longer.

Related how-to guide

Destroy your debt

If your credit card bills and debts are getting you down it's time to make a stand - here are five easy ways to start.

See the guide

Finally, many borrowers fail to pay on time each month, often due to simple disorganisation or disinterest. The high cost of late-payment fees, especially multiple fees, isn't reflected in the APR. If it was, you'd perhaps realise how extraordinarily profitable these fees are for lenders, and costly to you.

There is also the indirect cost, which is that missing payments makes your credit history worse, and so future loans are likely to be more expensive.

3. Very few people obtain the typical APR

Four out of five lenders advertise not a single APR for all, but a 'typical' APR. You'll have read recently that the number of successful applicants who must be offered the typical APR has been reduced to half since 1 February 2011: 51% might get the typical rate, and 49% can expect a higher rate. Previously, lenders had to offer the typical rate to two-thirds. There's more detail in The EU is bumping up your credit card bill.

However, even that overstates the facts. Lenders can reject eight applicants out of ten and refer them to expensive, third-party, secured-loan lenders for a fat commission. (Be sure to tick/untick the right boxes during the application to avoid such referrals.) Then lenders could accept just two applicants out of ten, giving just one out of ten the advertised rate and the other one out of ten a higher rate.

Furthermore, the numbers offered the typical rate are just based on the lenders' projections, which aren't necessarily the reality. Should the Office of Fair Trading decide to investigate, it could challenge lenders to justify their projections, but we have to consider that these rules are perhaps too loose.

4. Repayment holidays

Lenders will frequently grant us repayment holidays at the start of a loan and even once per year. This gives us one to three months where we don't have to make repayments. Sometimes banks insist on us accepting their generosity by making the holidays compulsory.

You may have guessed from my unusual use of the word 'generosity' in connection with banks that this is far from an act of good will. During those months where you make no payments, interest is still charged on the whole debt. What's more, interest will be charged on top of that interest until you pay off your entire debt. This is not reflected in the APR figure, even though it could add hundreds of pounds to a reasonably modest loan.

5. PPI

We can't mention dodgy tricks without missing off the lenders' old favourite: hugely expensive payment protection insurance. The cost of this hideously pricey insurance is not reflected in the APR.

If you want to protect your income or debt repayments from unemployment or ill health and don't want to rely on savings alone, you should do some of your own research and look for a stand-alone provider for much cheaper plans and usually better cover as well.

A few tips

Don't just look at the APR. With personal loans, consider also the total cost of the debt and the monthly repayments. We make those figures clear for you in our loan centre, for example.

With credit cards, you shouldn't leave a debt on the high standard APRs. Either look for a 0% card deal, or a cheap personal loan, or pay down the debt very quickly.

For more help on checking the cost of cards, loans and mortgages, read Watch out for lenders' tricks.

More: Compare credit cards | Credit cards that bend the rules | Get a £2,000 refund from your credit card provider