Lenders define the Annual Percentage Rate (APR) as the “current cost of borrowing.” This definition is not very helpful in explaining the meaning of an Annual Percentage Rate for the average consumer. Luckily, there are other definitions. An Annual Percentage Rate is also a financial reflection of a mortgage loan’s total interest costs –averaged across the loan’s full term; in other words, over the life of the loan divided by how many months contained in that period. An APR works best as a comparative financial tool when shopping for a loan or a mortgage. This is because the APR indicates costs, fees, and interest rates. Read on to learn how the annual percentage rate measures the actual cost of a loan.
An Annual Percentage Rate provides a more in-depth, detailed financial perspective than interest rates offer. In theory, APRs means to help borrowers avoid comparing two completely different types of loans. While the Annual Percentage Rate does this, the APR can also be a tricky financial concept if consumers misunderstand them. In reality, this happens too often.
Suppose each lending institution charged the same fees and costs on every loan across the country. In that case, lenders could use the APR as a consistent comparative calculation with a reliable benefit. However, different lenders decide which fees to include in their Annual Percentage Rate calculations and omit others. So, loan costs vary significantly from lender to lender, which essentially reduces the Annual Percentage Rate calculation reliability as a comparison tool.
APRs Are Complicated but Can Be Understood.
Remember, lending is a risk-based industry. Risk is the financial idea that is the basis for how the annual percentage rate measures the real cost.
What Causes the APR to Fluctuate?
Several things cause an Annual Percentage Rate to move. Different factors impact how the annual percentage rate measures the actual cost of a loan.
- The Loan Type/Product
Some specific small loans have higher loan fees. Loans secured by collateral (secured by a home or automobile, etc.) have shown to be less of a risk to lenders. Borrowers usually pay their secured loans before their unsecured loans. Hence, auto and home loan rates are typically lower than unsecured forms of credit, like credit cards or personal loans.
- The Borrower’s Credit Profile
Their credit history determines a borrower’s credit trustworthiness. The best way to predict someone’s future financial behavior is the person’s past economic behavior. Those who show, over time, that they are willing and can pay their loan amount on time will receive reduced APRs on future loans.
- The Borrower’s Loan Payment Ratios
The loan’s payment compared to the borrower’s monthly income calculates the borrower’s debt ratios. If the loan’s monthly payment is $100 and the borrower earns $2,000 per month, what would you estimate the debt ratio?
Luckily, the calculation is basic grade-school arithmetic; It’s not detailed information.
Debt Ratio: 100/2000 = .05 or 5%
In the mortgage industry, there are technically two different debt/income ratios. The first ratio indicates the Debt Ratio for monthly housing expenses when compared to monthly income. The second ratio includes the borrower’s housing expenses plus all other debt, like credit cards, car loans, etc.
From an underwriter’s point of view, the lower one’s debt ratio, the less risky potential borrowers can be. Good ratios verify that the borrower is not too crazy with their borrowing goals.
A Detailed Look at Annual Percentage Rates
Before applying the APR as a comparison tool, it is essential to understand a few critical things about the APR concept.
Credit Cards and APR’s
The Annual Percentage Rate shows the interest rate a credit card user will pay if they pay the entire balance off each month. It is important to note that the APR calculation for a credit card does not include compounding interest effects. Credit card users, who decide to make minimum payments, will pay interest on interest (the compounding effect); avoid this at all costs! The results of compounding interest increase borrowing cost significantly.
A credit card APR is only about interest costs. So, when deciding which credit card is best, you must also compare lender fees separately. In some cases, how you plan to use the card will be important when comparing APRs. If that’s not enough, the same credit card might have several different APRs based upon whether the transaction is a balance transfer, a purchase, or a cash advance.
Mortgage Loans and APR’s
When speaking about the mortgage perspective, the Annual Percentage Rate is more complicated because the APR includes your interest charges and costs. As mentioned earlier, lending institutions choose which fees to include in the Annual Percentage Rate calculation. When it comes to mortgage loans, a potential borrower must evaluate the APR and many specific concerns connected to mortgages. The mortgage loan’s Loan-to-Value (LTV) traditionally impacts the Mortgage loan APRs.
How Long a Borrower Plans to Pay Back Their Loan Impacts the Annual Percentage Rate
The length of time you plan to use the loan funds is a critical part of anyone’s loan decision. A sizeable up-front fee will increase your loan cost, but the Annual Percentage Rate will calculate the loan costs throughout the loan. If you intend to keep the loan for a minimal amount of time, the actual APR is naturally going to be higher. For loans paid off quickly, the APR tends to understate the influence of costs paid at closing.
How the Annual Percentage Rate Measures the True Cost of a Loan (When the Initial APR Is 0%)?
A zero percent APR suggests that there is no interest charged for the monies borrowed. Borrowing without any interest costs is ‘too good to be real.’ Take note, though, zero percent APR loans seldom last for very long.
Some useful meanings:
Loans usually have either fixed or variable APRs. A fixed APR loan has an interest rate that is guaranteed not to change for the loan’s length. A variable APR loan has an interest rate that may change.
Understanding Interest Rates Interest is basically a rental or leasing charge to the borrower to use an asset. When it is a sizeable asset, like a vehicle or building, the lease rate might serve as the interest rate. When lenders judge the borrower to be low risk, they typically charge a lower interest rate. If they deem a borrower as too high risk, the interest rate will be higher. Risk is determined when a lender looks at a prospective borrower’s credit score or credit report. It’s essential to have an excellent one to qualify for the best loans.
For loans, lenders apply the interest rate to the principal, which is the original loan amount. The interest rate is the cost of debt for the borrower and the lender’s rate of return.
Simple Interest Rate
The examples above are calculated based on the annual simple interest formula, which is:
Simple interest=principal×interest rate×time
The person who took out a mortgage would have to pay $45,000 in interest at the end of the year if it was just a one-year lending agreement. If the term of the loan were for 20 years, the interest payment would be:
An annual interest rate of 15% is a yearly interest payment of $45,000. After 20 years, the lender would have made $45,000 x 20 years = $900,000 in interest payments, explaining how banks make their money.
Compound Interest Rate
Some lenders use the compound interest method, in which the borrower pays even more in interest. Applied to the principal but also on the accumulated interest of previous periods, Compound interest is also called interest on interest. The bank calculates that the borrower owes the principal plus interest for that year at the end of the year. The bank also calculates that at the end of the second year, the borrower owes the principal plus the interest for the first year plus the interest on interest for the first year.
The interest owed when compounding is higher than the interest owed using the simple interest method. The interest is charged monthly on the principal, including accrued interest from the previous months. For shorter time frames, the calculation of interest will be similar for both methods. As the lending time increases, however, the disparity between the two types of interest calculations grows.
Compound interest=p×[(1+interest rate)n−1]
where: p=principal n=number of compounding periods