Time to level the repayment field

APR values on loans were introduced to make things clearer to customers, but it's all got hopelessly confused. By John Andrew

CONFUSED ABOUT APRs? You may well be. This basic yardstick, the so-called Annual Percentage Rate, which aims to measure the true cost of credit, has been pulled and stretched in so many different ways since it was first introduced that many would-be borrowers are completely baffled as to what it really means.

To make matters worse, the way in which APR is calculated is changing again, courtesy of new rules laid down in a European Credit Directive, adopted by all EU countries in February this year.

The Department of Trade and Industry (DTI) has issued a consultation paper with its own proposals on how to implement the directive. Comments are invited by the end of this month. The problem is that not only are the DTI's current proposals likely to confuse people, but the way they are framed means some borrowers may be encouraged to take out endowment- style mortgages in preference to any other type of home loan. What is APR all about, anyway? An Office of Fair Trading (OFT) leaflet published in 1980, when the APR was launched, explained that it was a simple measure which would show the true cost of credit, as it included all the charges that would have to be paid to obtain the finance being offered. It promoted the maxim: "The lower the APR, the better the deal".

However, since 1980 the Regulations have excluded certain items from the APR, which had to be paid in order to obtain the credit. These included the insurance of buildings, though it is a condition of all mortgages that the property is insured. However, it is the end of the exclusion of life insurance cover from the APR formula that is now causing worries, though this had not been a problem until the intervention from Brussels. This is because although the directive also generally excludes the cost of insurance and guarantees, it goes on to require the inclusion within APR calculations of those "designed to ensure pay- ment to the creditor, in the event of death, illness or unemployment", which are a condition of obtaining the credit. The UK's present position of excluding all life-insurance premiums clearly does not fully reflect the requirements of the directive. The main reason for their exclusion was because of difficulties associated with calculating the APR for an endowment mortgage. This is because such a policy has two objectives, not one: to provide life cover to repay the lender should the borrower die, and to provide a large enough lump sum to repay the loan at the end of the mortgage term.

As the cost of the life cover forms an integral part of the endowment premium, and is not shown separately, the decision was taken to exclude it from every APR calculation, whether related to a personal loan or a mortgage. The DTI recognises that the problem remains. Therefore, it is proposing to exclude the premiums payable to a life company in the calculation of the APR for endowment mortgages.

However, the DTI consultation paper goes on to say: "It is clear that payments of pure life insurance premiums, where the creditor makes it a condition of the provision of credit, should be included." In other words, for a repayment mortgage, the APR will include the premiums for life cover. However, the APR for an endowment mortgage will not. The result will be an un-level playing field. The APR for a repayment mortgage will be lower than for an endowment mortgage. Borrowers applying the maxim "The lower the APR, the better the deal", without further consideration, inevitably opt for an endowment mortgage.

It was not so long ago that the regulators were concerned that mortgage providers, insurance companies and independent financial advisers were biased in favour of recommending endowment mortgages to borrowers. The suspicion was that, as this route resulted in lenders and salespeople earning hefty commissions, they steered borrowers towards endowment mortgages and boosted their profits.

The regulatory process for the sale of mortgages is much tighter now than it was in the late Eighties and there should now be no mis-selling by mortgage providers - not that there is any guarantee of that. In any event, not all home-buyers seek advice as to which type of mortgage is best for them. Should the DTI's initial proposal go ahead, the Government itself will be introducing a bias towards the endowment, as opposed to the repayment, mortgage. This is a highly dangerous move. Nevertheless, there is a way forward. Given that the directive requires life cover to be included, it should be done with all APRs, regardless of how the principal of the loan is repaid. One way this could be achieved is by including the cost of premiums for life cover in a repayment mortgage, into the APR for an endowment mortgage.

Forget for a minute that an endowment policy has a single premium. Every life company sells pure life assurance and endowment policies. When calculating the APR for an endowment mortgage, the lender should be made to include the notional premium that the borrower would pay for pure life cover in a repayment mortgage. To offset the possibility of bias, this would have to be from the same life company that provides the endowment policy. Borrowers could therefore compare like with like. When the DTI has sorted that one out, it should then turn its attention to imposing a uniform way of calculating the APR for fixed-rate mortgages.

Currently some lenders assume that the fixed rate is in force for the entire period of the mortgage. Others, reasonably, assume that after the period for which the rate is fixed it reverts to their current variable rate. The result is that lenders who take the latter approach, which is more sensible, then appear to have far more expensive mortgages, placing them at a disadvantage in the home loan market. Either that, or borrowers become hopelessly confused.

By standardising the calculation of the APR for fixed-rate mortgages, the APR might then be the useful yardstick intended, not a meaningless set of initials that no longer deliver on the promise made on their behalf when they were first introduced.