Watch out for lenders' sneaky tricks!

We explain what APR is and why it isn't a reliable measure of the cost of loans, mortgages and credit cards.

The Annual Percentage Rate (APR) is supposed to make it easier to compare loans, mortgages and credit cards, but that's no good unless we understand what it means and what its limitations are.

APRs should incorporate all the costs - the interest and charges - and calculate them as a single annual rate. It's calculated differently over time as laws change (and mostly improve), with the most recent changes occurring in 2007 and the most significant in 2004.

How many people get 'typical' APR?

Those significant changes were to typical APRs.

Where a 'typical APR' is advertised, lenders are expected to give the rate to two-thirds of the people it accepts. This means it could reject 1,000 applicants (and perhaps offer them another more expensive product instead) and accept, say, 150. Of those 150, 100 should get the typical APR and 50 will get a higher rate.

In practice, it could be that somewhat less than two-thirds get the typical rate, because it's all based on the lender's projections, not on the reality. The lender is supposed to be able to support its projections with quality evidence if challenged by the Office of Fair Trading, but I fear these rules are still too loose.

Credit cards

Credit cards are an expensive way to borrow unless you're on an introductory 0% deal or you pay off your purchases in full each month. Otherwise, you should look for cheaper alternatives or seek debt advice if you're unable to get these alternatives. It's also extremely rare that premium cards, which come with annual fees, are worth the money.

For these reasons, the APR on a credit card shouldn't be relevant to most people unless you've secured a low APR card.

Nevertheless, here's how APR works with cards. If there are no annual or other fees, and if you're not taking out the overly-priced payment protection insurance, it will be easy to compare with other similar cards using the APR. The one with the lowest APR should be the cheapest.

Premium credit cards

Normally lenders do what they can to make APRs look as low as possible, but since 2004 the rules for cards have become very strict. The APR is always calculated on the assumption that credit is provided for one year and repaid in 12 equal instalments at monthly intervals. If it was calculated over a longer period, it would make the rate seem lower.

Also, the advertised APR is based on a credit limit of £1,500 - unless the credit limit is to be less than that amount, in which case it is based on the real credit limit. If lenders based the APR figure on a higher credit limit it would have the effect of lowering the APR (although you'd still pay more).

This can have quite a dramatic effect on the interest rate advertised. Take the Royal Bank of Scotland's Black Card, for example. It has an interest rate of 12.42% and a £250 annual fee. The minimum credit limit it will grant is £15,000, meaning at worst its APR is 16.8%. However, it's required to base its advertised APR on a credit limit of just £1,500, like all other cards. This boosts its advertised APR to 51.8%.

This may make the cost seem artificially high, but it's still better for the consumer. If lenders used different credit limits it would make the APR figure useless, as you would not be comparing like with like. This method would be a problem if you tried to compare cards with and without fees simultaneously, but there should be no reason to do that.

Personal loans

Personal loans include both secured and unsecured loans. The APR for loans is based on the length and total amount of the loan.

If there are no arrangement or other fees, and you're not taking out the expensive protection insurance, the APR should tell you the interest you'll pay each year. If there are fees, the APR will be higher to reflect this. (If the cheapest loan you can get charges an arrangement fee, you should get debt advice, as there's probably a better alternative.)

It's a good rule of thumb that lower APRs are cheaper, but this isn't perfect. If you think you'll pay off your loan early, for example, it might make sense to go for a loan with a higher APR if the one with the lowest has an up-front charge.

Also, the APR can be manipulated, making it misleading. That's why it's best to ignore loan APRs altogether and look at the total and monthly cost of the loan.

However, lenders' tricks can also confound comparison on this basis. It's sensible to add a couple of pounds to the estimated monthly cost shown in comparison sites to take this into account. (lovemoney.com's loan comparison tables show as close an estimate to the true total and monthly amounts as you'll find in any comparison site, usually being no more than a few pounds out per month.)

You can then better estimate the real total by multiplying your new figure by the number of monthly payments you're making.

Lenders mess up total and monthly figures most when they have compulsory payment holidays, so be particularly wary in that case. Find out more in Five cheap loans that are true best-buys!

Finally, when you receive your contract, check the total and monthly payments, which the lender is obliged to display.

Mortgages

For mortgages, APR is a very questionable tool. Not only are there ways to manipulate it and leave out certain costs, but it's also calculated to the end of the mortgage. As many people switch every few years, this makes it inaccurate.

The best way to compare is to look at the total cost up until the time you think you'll re-mortgage. Add up all the charges and monthly payments up  until when you leave. Add on any expected solicitors' fees and other bills. Then add on any exit fee or redemption charges you'd have to pay. That's your total cost. You can now compare other mortgages using the same technique.

More: Buy now, pay later at no extra cost! | Beware these high risk homeowner loans