APR as a measure of cost 

I often get asked what we would need to do as an organisation to reduce our APR to below 100%.

Why am I asked this?

As I talked about in the introduction to this series there is a moral view in the UK that APR above 50% is not acceptable as it is extorting customers. However, APR alone doesn’t give the full picture for the cost of a loan, especially for small-sum, short term credit. Yet Moneyline, a not-for-profit lender is often asked about whether we can reduce our APR to a rate which investors, suppliers, other community and national organisations and the media might view as more ‘acceptable’. On the flip side, research shows that APR and the total cost of a loan is not the most important thing for the customer, it’s about if they can afford to make each payment. 

APR is not an appropriate measure for loans with a term of under a year. To simplify what is a complicated formula, it’s an annual calculation in which the cost of the loan is compounded again and again to see what it would cost over a year. In practical terms this means that while we would charge an interest rate of 59% on a short-term loan, this actually works out at an APR of 169%. It’s impossible for most of us to work out the cost of any loan under a year from its APR% and I haven’t met anyone who can do this and explain it in a simple and meaningful way.  

Given that one of the things we should strive to do in financial services is make things simple and clear for our customers to help them make sound financial decisions, APR is a very misleading way of showing people what a loan costs. Yet currently, it’s something we have to do to meet regulatory requirements.  

As a not for profit organisation who only wants to cover our costs, we are constantly trying to offer loans at the lowest viable cost to the customer. However to reduce APR below 100% we would have to start offering larger loans with a minimum repayment period of 12 months, or be grant-funded for some of our operating costs. We have seen a trend in the commercial market over the last few years where lenders of small cash loans are reinventing themselves by offering larger, longer term loans to lower their APR to a more palatable amount. This has substantially reduced the overall availability of small cash loans in the market. Moving to offering only longer term loans is not an option for Moneyline as this would move us away from our social purpose and would lead to us adding to financial exclusion as we would be leaving behind our customers that need small cash loans.  

The cost of delivering small cash loans 

But the fact remains that the cost of credit is still high for small, short term cash loans regardless of the measure so let’s look at that in a bit more detail. 

If we take Moneyline as an example, our cost of credit (not our APR which is currently 169%) is roughly 59% or for every £100 a person would borrow for a year they would pay £59 back. Our average loan for a new customer would be £400 over 26 weeks.   

In simple terms, the table above shows that issuing small cash loans over a short term and offering larger loans over a longer term have a large income difference for a lender. That sounds simple but is often lost when we are just focused on APR% or interest rate rather than the small sum cash product not generating enough income to cover the costs. Also, we always try to offer loans at the shortest term a customer can afford to keep the cost of the loan down for them. However, the direct cost of acquisition and delivery is the same no matter what value or term of loan we issue (and its about £80 for every new customer). Even with good quality customers we don’t make a profit by the time you have paid the overhead costs and some bad debts. That’s why you don’t find commercial lenders trying to do small cash loans at this price. 

If we continue to consider APR% as an appropriate measure for the cost of credit on short term loans we will see more and more products come to market that are focused on ensuring their APR stays low, rather than a focus on developing products that create good customer outcomes. This means small cash loans will become a thing of the past. We need to rethink how we explain the total cost of a product to the customer but also destigmatise the higher APR which social purposes and not for profit lenders need to charge for short-term loans. We need to recoup our costs and create a sustainable organisation, while giving customers an affordable product which they want and need. Our loans do save our customers money on the total they repay compared with the other alternatives they have.  

Click on the video below to listen to Michael Sheen, actor and activist, talk through APR.