Credit cards and APRs

What is an APR?
APR stands for annual percentage rate. It is an indication of what a lender will charge you for your loan.

So far so simple, what's the problem?
People have different methods of calculating it... and they come up with different answers.

Which people?
Two of the bodies involved in credit card consumer issues: the Office of Fair Trading (OFT), which is a government agency, and the Association for Payment Clearing Services (APACS), which is an association of major banks and building societies.

What are the methods?
Your intrepid researcher has looked through the calculations and they involve differentiation and Newton-Rapheson methods of successive approximation. Believe me, even with a science degree, you don't want to know the details.

Okay, so why do they differ?
Basically, the length of time that you take out a loan for, and the rate at which you pay it back, will affect how much the loan costs you. The OFT believes that this should be factored into the APR along with the monthly interest rate and APACS does not.

Why does the OFT think that?
With the OFT "blended rate" you can compare advertised APRs and all you have left to decide is whether you are interested in bonuses such as loyalty points and whether you can afford the minimum monthly payment.

So, it's great for working out whether you should buy that stereo system using monthly instalments to Dixons, or all at once with an Egg card?
Exactly. It is a good approach for things like getting a mortgage or buying a sofa. In these cases there is a fixed original amount for the loan and probably fixed payments over a set amount of time.

But how do they know when I'll pay back my credit card, or even how much I'll borrow?
They have to make assumptions about how you will use your credit or store card.

What are the assumptions?
The OFT assumes the worst. It works out how long the loan would take to repay if you maxed out the card on the first day you got it and then paid off the minimum each month. These assumptions give them a theoretical lifetime of the loan which they can use in calculating their APR.

But I've got a credit limit of three grand. I'll never use that (probably).
Here lies the problem. If you are unlikely to borrow the maximum, then the limit on a card should not affect your choice, but the blended rate does not let you ignore this factor. The same card with different limits will have different APRs and they may not reflect what you will actually be paying for the loan. This makes it difficult to choose the best card.

Furthermore, if you regularly pay off more than the minimum monthly requirement, then whether a card requires 3% or 5% should be irrelevant, but the former will have a lower APR according to the OFT, and will look like a better deal.

Is this where APACS comes in?
Yes. Their approach calculates APR over a one-year period in all instances so they do not have to make such assumptions.

Great, let's all use APACS.
Not so fast. Lots of cards offer introductory rates for six months. With a theoretical lifetime of the loan, you can calculate a weighted average of the introductory rate and the "go to" rate to come up with a reasonable APR.

The APACS method simply leaves out all introductory or promotional rates and just uses the "go to " rate. This is why "blended rates" often look lower than "standard rates".

So with APACS's method I have to take into account APRs, introductory rates, and loyalty points when comparing cards. Anything else?
Don't forget annual fees. Though fewer cards are charging them, you should know that the OFT blended rate takes them into account and APACS does not.

I get it - disadvantages to both approaches. So how do I know who is using which method?
You don't. There is widespread confusion among card issuers as to which method they should be using. Advertised APRs could have been calculated using either OFT or APACS rules and you will not get anything helpful out of your average phone call.

What can I do?
Wait for the Treasury select committee inquiry into transparency of credit card charges to sort it out.

In the meantime, you could always pay off your balance in full each month. If your card has an interest free period (normally about 56 days), this means that you will never be charged interest. Then you do not have to worry about the APR at all.

Cheers, but I'm not quite that perfect. Any other advice?
Be honest about how you are likely to use your card, devise a simple borrowing scenario and work out the interest for the three best looking cards. Just remember that there are different methods of charging interest, even if cards have an identical APR calculated by the same method.

What!
I'm afraid so. A Which? survey looked at when different card providers start and stop their interest calculations. They found six distinct methods. Even given identical scenarios with an identical APR, one method ended up charging almost twice as much as another.

Is there any good news?
Thanks to huge competition, the interest charged on credit cards generally has decreased dramatically over the past few years. Just be careful around the new store cards...

Useful links

Credit cards comparison

Office of Fair Trading

APACS

Treasury select committee