A yardstick of variable length

After 22 years, the APR has become a nonsensical shambles. Andrew Moore reports

You would think, in these cost-conscious days, that the price of money, i.e. the rate of interest, would be carefully defined and measured. It should be, but it is not. The law says that every interest rate should be expressed as an APR or annual percentage rate of charge, to help make fair comparisons.

But the definition is now quite meaningless as a way of comparing the cost of personal loans, mortgages, credit card balances and the like.

APRs were introduced in the Consumer Credit Act of 1974 in a worthy attempt to provide for 'truth in lending'. Twenty-two years later, thanks to a failed public education programme, poorly drafted and highly complex regulations, odd decisions taken by the body giving guidance to those who enforce the regulations and abuse by credit providers have resulted in a shambles.

A survey conducted by the Office of Fair Trading in 1994 found that only 11 per cent of respondents knew its use, though nearly half of those asked knew what the initials stood for.

The APR is intended to indicate the true cost of credit and be used as a yardstick to help consumers identify the best credit deal.

As well as interest, the APR includes all other charges that affect the cost of borrowing, for example, arrangement fees and any legal costs for taking security, such as a mortgage, over property. All the costs are annualised. Advertisements for consumer credit below pounds 15,000 and all mortgage promotions must also include an APR if an interest rate is featured. Gone, therefore, are the days when lenders could promote credit with just 'flat' annual or monthly interest rates, ignoring all other charges borrowers would have to pay to obtain credit.

Unfortunately, as a result of a chain of events and abuse by certain lenders, the APR is now a useless yardstick and consumers are in the same position as they were before the Consumer Credit Act and its sundry regulations came into force.

The regulations governing advertisements are among some of the most complex rules ever published. The situation is further aggravated by the fact that these regulations are out of touch with the real world.

They do not recognise that credit cards with annual fees or fixed-rate mortgages exist. To calculate an APR for a credit card where there is an annual fee requires an assumption to be made about the average line of credit.

Whereas most of the main players base their APRs on the basis of the average line of credit being pounds l,000, others use a pounds 2,000 basis.

This makes it impossible to use the APR as a yardstick. For simplicity, assume that the annual fee is pounds 20. If a credit card issuer uses a pounds 2,000 base as opposed to a pounds l,000, there is an immediate advantage of 1 per cent as pounds 20 as a percentage of pounds l,000 is 2 per cent, but 1 per cent of pounds 2,000.

There are other situations where advertisers are not adopting a level- playing-field approach. For example, to attract new cardholders, credit cards are often promoted with a fee-free first year. The advertisements feature APRs based on interest only, but compare this with the fee-inclusive APR of their competitors, despite the fact that they may also may offer a fee-free first year. The small print in some advertisements is so complex that it is impossible to be sure of the basis on which the comparison is made. As a consequence, the APRs for credit cards are useless yardsticks.

Of course, fees for credit cards were not in force in 1989 when the regulations were last updated. However, fixed-rate mortgages were available, but the regulations remain silent as to their existence. As we shall see, events have had a knock-on effect with the recently introduced discount rate for mortgages.

When fixed-rate mortgages became common in the mid-1980s, lenders initially based their APRs on the assumption that the fixed rate would last for the entire period of the mortgage.

However, a little later the general consensus emerged among lenders that this was not appropriate and they began to calculate the APR on the basis that the rate was fixed for the contracted period and then reverted to the then current variable rate for the remainder of the mortgage term.

Although the new approach received the blessing of Trading Standards Officers (TSOs), not all lenders followed the industry practice. In 1990, a Devon TSO brought a successful action against NatWest. The bank appealed and in 1992 won the case.

The judge's reasoning was that a fixed-rate mortgage could be followed by another period of interest at a fixed rate. The nation's TSOs were horrified and the mortgage industry was thrown into disarray.

Today almost all lenders base their APR calculations for fixed-rate mortgages on the assumption that the fixed rate will prevail for the entire mortgage period. However, there was a more serious development after the NatWest court case. Lacots, the representative body for TSOs, advised lenders who offered a discounted rate for an initial period, to base the APR on the assumption that the lower rate will prevail for the entire period of the mortgage.

This is an absolute nonsense. If a lender offers a discounted rate of, say, 1 per cent for one year, there is no way that it will prevail for the full 25-year term of the mortgage.

However, with the blessing of the nation's TSOs, any lender promoting, say, a 6.5 per cent discount for a year on its 7.5 per cent variable rate mortgage, could promote the offer with an APR based on 1 per cent.

This would result in an APR of approximately 1.2 per cent. However, logically the APR should be around 7.7 per cent as for 24 years of the 25-year term of the mortgage, the interest payable will be at the lender's variable rate, currently around 7.5 per cent. It is incredible that those responsible for policing the legislation should have made a mockery out of one of its cornerstones.

In 1994, the OFT proposed a simplification of the regulations governing credit advertisements. Its then director-general, Sir Gordon Borrie, was especially concerned at the reams of small print that appeared at the foot of mortgage advertisements.

Look at most mortgage adverts in the press and the words 'information overload' immediately spring to mind. Look at the unreadable small print that wafts across the television screen as a mortgage commercial is screened and one wonders why it is there.

The whole way in which credit is being promoted needs to be examined. However, as an interim measure, it is imperative that consumers are given a level playing field so that the APRs are comparable. Above all, there needs to be a public awareness campaign to promote the use of APRs.

Consumer protection can only work when more than 11 per cent of the population know that the APR is a yardstick to help spot the best credit deal.