Whether you’re asking for a bank loan or applying for a credit card, the most important thing to consider is the APR. You will recognize it as the number expressed as a percentage that will basically indicate how much extra you will have to pay back to the lender. The problem is that many people tend to confuse APR with interest rate, thinking they are exactly the same, and this can cause problems down the road. To protect yourself from unexpected surprises, learn exactly what APR is, what types there are and how it is calculated.
What exactly is APR?
APR stands for annual percentage rate, and by definition it refers to the cost of borrowing money for example through a small business loan, personal loan or credit card. Besides borrowing, the amount earned from an investment in a year is also referred to as APR, such as the returns from an ETF, stock, etc. In the case of a loan, the APR will always be higher than the interest rate because it includes all the costs incurred by the loan from the lender. Meanwhile, the interest rate is only the cost of borrowing the principal loan amount without accounting for the other costs.
All these are additional costs not covered by the interest rate of the loan but still worth considering. Therefore, compared to only the interest rate, APR is a much more reliable measure of how much a loan will actually cost you so that you can effectively compare different lenders. For instance, two lenders may have the same interest rate but they will differ in the other charges.
Some of the costs commonly included in a loan include:
- loan application fee
- loan processing fee
- underwriting fee
- document preparation fee
These are common loan fees across the many types of financing made available, but there are others sometimes added by some lenders. Those you may come across in your application may be:
- credit report
- attorney fee
- abstract fee
- transfer taxes
- title fee
APR and TILA
Even the law acknowledges the importance of APR in lending, which is why it was mandated by the Truth in Lending Act (TILA). This legislation was passed in 1968 in order to ensure that borrowers were treated fairly when receiving credit and loans from lenders. It was also meant to create a standardized manner in which the cost of borrowing would be represented so that borrowers could be more informed about what they were getting into.
However, TILA does not dictate what charges lenders can charge because they are still free to set their own rates; the law only requires that lenders be open about their charges. To enforce TILA, the Federal Deposit Insurance Corporation (FDIC) is responsible for ensuring lenders are adhering to the law. The FDIC ensures that all loans are following the law in terms of periodic rates, finance charges, tolerance and good faith reliance. Fortunately, you don’t have to bother yourself with the details as you can trust FDIC to keep an eye on the financial institutions.
For two decades since the inception of the law in 1968, it was very effective in keeping lenders honest. Then in the 1980s some lenders, especially auto manufacturers, took advantage of a loophole in TILA. These lenders take advantage of the fact that ‘amount financed’ and ‘finance charges’ were not totally differentiated. For this reason, they were able to completely get rid of the finance charges by transferring it all to the ‘amount financed’ category.
Thus, lenders were able to claim they provide zero APR financing and now borrowers were able to receive interest free loans. For instance, some auto lenders who provide these zero APR financing and not charge any interest whatsoever will also require a charge a $1,000 rebate. Because the lenders can set their own charges by taking advantage of the loophole, the amount charged as rebate can be higher or lower than APR.
Tila Regulation Changes
Since TILA was passed in 1968, there have been very many amendments to the legislation. Some of the most important changes include the CARD Act of 2009. This amendment targeted credit card issuers by requiring them to disclose important information to anyone that applied for a credit card and to provide a notice before raising interest rates. By 2015, the Consumer Financial Protection Bureau (CFPB) reported that this amendment had saved consumers $16 billion – $7 billion in late fees and $9 billion in over-the-limit fees.
The bad news, though, is that zero percent APR financing is still being offered by some lenders, and this can sometimes take advantage of the borrowers who are unable to receive funding from conventional sources.
What are the types of Annual Percentage Rates?
When borrowing money or using a credit card, most people focus on one form of APR. This is not a problem when asking for a bank loan, but credit cards have varying types of APR that you should be aware of. The most obvious is the purchase APR, which is charged whenever you use your credit card to purchase goods and services. If you happen to violate any of the terms set out in the agreement with the credit card provider such as being late on the payments, a different APR will be applied – penalty APR. Since this is charged after a violation, the APR is usually higher than the purchase APR. Then there is a different APR charged when you use a credit card to borrow money either by cash, check or transfer to another credit card. The APR here is also much higher than the purchase APR and there are often no grace periods on repayment.
That being said, another common form of APR you are most likely to encounter is the promotional APR. Some lenders will also refer to it as an introductory APR, but they both refer to a lower APR offered by a credit card issuer to entice you to take the credit card. The terms of the promotional APR will vary, but they can be as attractive as zero percent APR or, more commonly, a reduced APR.
When considering this form of APR, it is important to remember two factors – length and limits. In most cases, the promotional APR only lasts for a limited time between six months and a year. Once this period is over, the APR will automatically adjust upwards to the standard APR from the lender. Banks and issuers will also impose limits to the types of transactions that would enjoy this lower APR. For instance, a lender may only give promotional APR for purchases but not cash advances or transfers. All these ought to be specified in the fine print, and it is important to be aware of what you are getting into.
Although there are several types of APR as described above, they all fall into two categories – variable and fixed.
How do variable and fixed APRs compare?
From the names, you should already be able to deduce how these two types of APR differ. The fixed APR, also called non-variable APR, is that where the APR does not change throughout the length of the lending relationship. For a bank loan, this means that the rate stays the same until the entire loan is paid back. For a credit card, this means you can enjoy the same rate indefinitely. The benefit of a fixed APR is that there are no surprises and one is thus able to plan their expenses all the way. Despite claiming to provide a fixed APR, some credit card will add some exceptions that would allow them to change the APR based on factors such as market conditions or depending on your usage. To confirm that you are dealing with a truly non-variable APR, take some time to read through the fine print in detail.
On the other hand, a variable APR is open to change depending on any factor the lender deems relevant. Of course, the good news is that they aren’t allowed to do this without adequate reason so there is no need to be wary. These lenders therefore use the prime rate as a reference to changing the APR. The prime rate is an interest rate determined by the federal funds rate and the bank’s overnight rate. To find the variable APR, this prime rate is added to the margin the bank issues to find a final figure. Banks use this prime rate to calculate various loans including bank loans and even credit cards.
TILA also dictates how lenders can change their APR so as not to inconvenience their clients. First, credit card issuers must notify their clients that they are changing the APR 45 days prior to doing so. Second, 21 days must be given as a grace period from the time a monthly statement is given to the due date. Finally, a company must assess if the borrower has the ability to pay back the loan before they can offer them financing.
Why Is Fixed Rate APR better compared to Variable Rate APR?
Inasmuch as there are risks to using variable APR, it does have some benefits. The most important is that an individual can get to enjoy lower rates in certain market conditions. Recently, the Federal Reserve cut interest rates by 25 basis points, which means lower prime rates and subsequently lower APR. That being said, lenders also take into account delinquency rates to estimate the risk in providing funding. The Federal Reserve Bank of St. Louis recently reported 2.59% in delinquency rates last seen in 2013, and this means higher risk for commercial banks and higher APR.
These and more measures determine the variable APR at any point in time. Most banks and credit card issuers prefer to use the variable rate because it protects them from changing market conditions. That also means lenders have to be prepared for unexpected conditions at any time. It is also important to remember that you can always get a lower APR if you have a higher credit score.
Some lenders will also have a tiered APR where the APR varies depending on the category of debt. As an example, a credit card issuer may charge a lower APR of 4% for debts below $1,000 and raise this to 7% once the debt exceeds $1,000. Again, these APRs could either be variable or fixed but the terms follow a different structure.
How to Calculate APR
There are several ways to calculate APR before you take any loan and know how much you will have to pay at the end of it. To get the exact figures, you will first need to find the interest rate charged, how much you are borrowing, the term of the loan and any other fees. Next you will have to determine what kind of loan you are taking because some like payday loans have a one-time repayment and others like a mortgage or bank loan are compounded every month.
To calculate the APR for an installment loan, you will need to find out the loan amount, loan term and the monthly payment. Let’s take a case of a $10,000 loan to be repaid in 5 years through $250 monthly payments.
- Calculate the total amount to be paid back – $250 * (5 * 12) = $15,000
- Calculate the interest paid – $15,000 – $10,000 = $5,000
- Divide the interest by the number of years – $5,000 / 5 = $1,000
- Divide the annual interest by total amount paid – $1,000 / $15,000 = 0.066
- Multiply by 100% to find the percentage rate – 0.066 * 100 = 6.6%
For calculating the APR on a credit card, the formula is – (1+[i/q])q-1
Here, ‘i’ is the annual interest rate and ‘q’ is the number of times you pay in a year. If the interest charged by the credit card issuer is 18% and payments are made monthly, the APR would be:
(1+[0.18/12])12-1 = 0.195 = 19.5%
In both illustrations above, the additional costs involved in the loan have not been included, but there are often costs associated that have to be considered. Doing this makes the calculation a lot more tricky, but with the Google spreadsheets you can quickly discover the APR or any loan. The formula begins with finding the monthly payments using the PMT function. PMT represents annuity payments and it can be used in any spreadsheet application:
=PMT (interest rate/months, total number of months you pay on the loan, loan value plus fees)
Assume an individual borrows a $10,000 loan at an interest rate of 12% to be paid back in two years plus a $500 closing fee to the bank. Here, the monthly payments would be:
=PMT (.12/12, 24, 10500)
Monthly payments would be $494. 27. With this, you can now get the APR using the function:
=RATE (total number of months you pay on the loan, your monthly payment expressed as a negative, the current value of your loan)
=RATE (24, -494.27, 10000)
The monthly rate is now found to be 0.0141 and this is multiplied by 12 to get the annual rate of 0.1692. Now multiply this number by 100 to get the percentage figure of 16.92%, which is the APR.
From these calculations, you can now see that the APR is higher than the interest rate that was issued as 12% by the credit card provider at the time of application for the loan.
Apart from using spreadsheets, an even easier way of figuring out the APR is through one of various online calculators. These automatically give you the APR from only the principle amount, interest rate, charges and loan term.
How effective is APR?
Back in 1968 when legislators declared that APR would be the standard representation of charges, they did so to make things more convenient for borrowers. Nonetheless, they did not consider some of the limitations of using APR to calculate the actual costs incurred when borrowing money. For starters, there is no clear definition of which fees should be included in the APR and which ones left out. Due to this, lenders can pick those fees they would prefer to include in their APR and thus they can alter the APR to suit their needs.
Additionally, some costs incurred may fail to be considered in calculating APR such as fees for late payments. The lenders think of these as separate from the rest, but some borrowers may disagree. For these reasons, anyone borrowing from these lenders would have to calculate the APR on their own to determine the actual APR they are paying. Financial experts have come to believe that APR would be best used for long-term loans of, say, 30 years instead of short-term loans of 3 to 5 years.
That being said, APR is not completely worthless because it still does give a borrower an idea of how much they will be paying in total. Add to that, the APR is effective when comparing loan offers from different lenders just as the legislators intended more than 5 decades ago.
