Your Money Loans: Keep a close eye on the APR

Simon Read introduces a four-page special report on how to manage your money, with a look at how to compare the true cost of credit

When a friend of mine heard that I was writing about credit and loans, he was eager to show off his knowledge of the subject. APR was the important thing to remember, he told me brightly. "It means you have to pay your interest annually, in April. It's the end of the tax year, you see."

I didn't have the heart to disillusion him - but he'll no doubt learn a sharp lesson if he tries to borrow from the bank manager before Christmas and not pay anything back until April.

As anyone who has even thought about borrowing money ought to know, the APR, or annualised percentage rate, is simply a benchmark figure that compares the cost of different loans. So whether you are looking for an occasional overdraft to stretch your pay cheque, or working out the best way to pay for that new car or kitchen refit, you should look at the APR,

Lenders were forced to show the APR figures because of increasingly contradictory and misleading claims from lenders, which made it difficult for anyone other than rocket scientists to work out which was the best deal on offer.

Which is cheaper, for instance - a loan charging 1 per cent a month or one costing 3 per cent a quarter? The APR provides a reasonably level playing field for consumers to judge the cost of interest rates quoted in different ways.

Sadly, it's not infallible - because it does not always take into account the charges which may be involved. So the APR is a better guide to comparing the same type of credit from different lenders (such as one bank loan against another) than, say, to weighing up a bank loan as opposed to an overdraft.

With an overdraft, the APR is based only on the interest charges. Since most overdraft deals involve various fees and charges, the cost will generally be much more than simply the quoted APR.

Some banks will quote an effective annual rate (EAR) to take these factors into account but, confusingly, most lenders still quote APRs. For a real comparison, therefore, you need to take into account all the extra fees and compare the monthly interest rates quoted.

With personal loans, the APR doesn't include the cost of credit insurance, which can add a considerable amount to the cost of the loan. While insurance may be wise, it is not compulsory.

With credit cards, the APR doesn't reflect the fact that many cards have interest-free periods. With up to 56 days' free credit available, it could be that by judicious use, your credit card could have a 0 per cent APR: if you get your timing right you will pay no interest at all. As with an overdraft, it's worth looking at the monthly interest charged and taking into account any monthly fees. However, if you're using a credit card for long-term borrowing, then the APR is a reasonably good way to compare the costs of different cards.

When it comes to gold cards, the confusion goes even further because the APR is worked out on the basis of an average balance of pounds 2,500, compared with an average balance of pounds 1,000 on normal cards.

This further distorts the comparison figures, but, again, the APR is a useful way of comparing the cost of one gold card with another