A look at the real cost of borrowing money - and why APR doesn't give the full picture

When you apply for credit - whether it's a loan, credit card, overdraft or mortgage - you'll be quoted an interest rate. This is usually the APR (Annual Percentage Rate) - in other words, how much interest you'll pay over a year (plus any other fees).

However, unless you are borrowing money for exactly one year, the APR isn't all that clear. It can make short-term loans look more expensive than they really are, and makes the interest on longer-term loans look smaller.

We've created the handy loan interest calculator below to help you work out what you're really paying in interest. Or if you'd like to know more about how loan interest works, keep reading.

What exactly is APR?

APR, or Annual Percentage Rate, describes how much you'd pay in interest and charges over the course of a year on your loan, credit card, mortgage or any other borrowing.

Lenders are legally required to provide the APR on advertising, or when providing you with a quote for credit. However, the calculations required to work out the APR are based on longer-term borrowing, and aren't designed for calculating interest on payday loans.

It's designed to be helpful when looking at how much interest you'll pay on longer-term loans, such as a personal loan or a mortgage. For example, a £10,000 loan with a 9% interest rate would accrue £494 of interest over a year.

But it doesn't tell you much about how much a loan would cost you over several years, or indeed how much a short-term loan would cost. The actual figures may surprise you.

Why a payday loan may cost less than you think

You've probably read horror stories about payday loans with APRs in excess of 1,000%. However, this doesn't mean much, because payday loans are usually repaid within days, not years.

For example, how much interest do you think you'd pay on a £100 payday loan, repaid after 12 days, at 1,043% APR?

The answer is just under £20. This means you'd actually repay 20% in interest on top of the amount borrowed, or 20p per pound borrowed - not cheap, but certainly nowhere near 1,043%. If it was, you'd pay a massive £944 in interest.

A word of warning, though: a payday loan could get very expensive if you don't pay it back on time. The APR may not tell you much about the overall cost, but it can give you an idea of just how quickly interest could build up if you start missing payments.

Why a personal loan or mortgage may cost more than you think

Personal loans and mortgages are generally considered two of the cheapest ways to borrow money, in terms of interest. The average rates on a typical personal loan and mortgage currently stand at 7.5%* and 3.5%** respectively, compared with 17.3% for credit cards and 19.7% for overdrafts.

Again, this doesn't tell the full story. Loans and mortgages are repaid over several years, meaning the total interest paid will be significantly higher than the APR.

For example, a £10,000 loan at 7.5% APR repaid over five years would accrue £2,022 in interest overall. That works out at 20.2% interest, or just over 20p per pound borrowed.

And a £100,000 mortgage at 3.5% APR repaid over 25 years would accrue a massive £50,187 in interest overall. And that works out at 50.2% interest, or just over 50p per pound borrowed. (Bear in mind that mortgage rates change over time, so it's unlikely you'd pay exactly this amount.)

Notice the pattern? Because of the longer repayment period, a mortgage or personal loan works out more expensive in terms of interest than the payday loan, even though the payday loan's APR is almost 300 times higher than the mortgage APR.

*Based on a loan of £10,000 - Bank of England statistics **Based on a two-year fixed-rate mortgage at 75% LTV - Bank of England statistics

It's all about affordability

The APR may not tell you much about the overall cost, but it can help you compare how much different types of credit will cost over a similar period of time.

For that reason, a higher interest rate isn't necessarily a problem as long as you are only borrowing money for a short period of time - but for longer-term borrowing, you should always look for a low interest rate.

The most important thing is affordability. Before you borrow any money, you should always make sure you know how long it will take to repay, how much your monthly payments will be, and you should be sure that the payments fit comfortably into your budget.

A payday loan may not be the cheapest way to borrow money, but it could help if you have an emergency bill and no access to other types of credit - as long as you can pay it back quickly. If the alternative is a £30 overdraft fee and a mark on your credit history, a £20 payday loan fee may be a price worth paying.

On the other hand, if you have a credit card, it's possible to borrow money without paying any interest at all, as long as you can pay the balance on time.

And when it comes to affordable long-term borrowing, personal loans (or a mortgage if you're buying a home) are likely to be your best option.

When borrowing money, you should always take the time to shop around and compare deals. If you're not sure whether you can afford it, it's probably best left alone.