What is an APR and why does it matter?

What is an APR and why does it matter?

Are you thinking about buying a house or applying for a credit card? The APR of a loan is a critical aspect to understand when making borrowing decisions.

If you’ve ever borrowed money via a mortgage, personal loan, or even a credit card, it’s likely you encountered the acronym “APR” somewhere in the documents outlining the terms of the credit agreement. APR stands for “annual percentage rate” and is a term that is critical to understanding the true cost of borrowing funds.

Believe it or not, in the United States “APR” is a specifically-defined term that is governed by provisions in the Truth in Lending Act (TRILA), which initially became effective in May of 1968. While TRILA has since been amended by famous laws such as the Credit CARD Act of 2009 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, APR was a foundational aspect of TRILA. Prior to the passage of TRILA, deceptive practices by lenders often made it very difficult for consumers to understand the true cost of financing.

How is the APR calculated?

Broadly, there are two different types of loans: open-end and close-end. An open-end loan is something like a credit card for which there is not a defined term set for the loan. A 30-year fixed mortgage, by comparison, is a closed-end loan because there is a set number of years over which the loan must be paid.

Open-End Credit APR Calculation

In the United States, APR for open-ended loans is calculated as follows:

Monthly rate X 12 = APR

If you have a credit card that charges 18% interest per year, or 1.5% per month, then the APR is calculated by multiplying 1.5 X 12 = 18%. Easy enough!

Things get more complicated if there are fees involved. Let’s say you have a credit card that advertises an 18% interest rate on cash advances but which also charges a minimum of $50 in order to access that cash. In situations like this, the APR is calculated as follows:

(Total finance charge / all balances + other amounts on which a finance charge was imposed

during the billing cycle without duplication) x 12 = APR

If you get a $1,000 cash advance and pay the $50 cash-advance fee, then the total finance charge for the year would be $180 + $50 = $230 or $19.17 per month. Using the above formula, $19.17/$1,000 = 1.92% X 12 = 23.04%.

As you can see, the $50 cash-advance fee raises the APR from 18% to 23.04%. For a consumer evaluating her credit decisions, it would be very important to understand that the cash advance increases her effective interest rate by almost a third!

Closed-End Credit APR Calculation

The calculation for an APR of a closed-end loan is broadly similar to that of the above calculation for an open-end loan. For a closed-end credit loan under TRILA, the APR is a function of:

  • The amount financed
  • The finance charge
  • The payment schedule

Closed-end credit loans such as mortgages commonly have a number of fees associated with them which, while not specifically interest on the money borrowed, do increase the cost of the funds to the consumer.

For instance, if a homebuyer borrows $100,000 at an interest rate of 4% per year (.333% per month) via a lender that charges a $1,000 finance charge and a $50 credit report fee, then the total cost of borrowing that money is actually:

[(.333% X $100,000) + ($1,000/12) + ($50/12)] / $100,000 X 12 = 5.05%

Because of the 1% finance charge, the effective cost of borrowing these funds for this borrower is actually more than 26% higher than it appears based on the interest rate, alone.

What does APR tell me?

At its core, APR tells you what the effective interest rate is for an entire year as applied to some sort of loan or credit card. It is a good, though not perfect, tool for understanding the true cost of utilizing that credit in the form of an annual rate.

In the United States, APR has been criticized for its shortcomings that can result in a major understatement of the true cost of credit. The period used for compounding, for instance, can result in a higher effective interest rate being paid by a borrower. This is important over a long time horizon as compound interest begins to kick in. Additionally, APR does not encompass one-time fees that are not paid to a lender but are required to be paid in the course of a transaction. A common example of this sort of fee is a required fee paid by a borrower to an attorney in order to secure a mortgage.

However, if you are comparing different lenders for a potential loan, APR is at least a great place to start in order to understand the cost of the various products being offered to you.

Why does the APR matter?

The APR is a truer cost of borrowing funds than the interest rate alone because it takes into account associated fees and loan-related costs that the borrower must bear in order to have access to funds.

The APR becomes critically important when making a mortgage decision for a home. It is not uncommon for a lender to offer a very low interest rate (compared to other lenders) that comes with higher fees that must be paid in order to secure that rate. Comparing the APR offered by a particular lender to that of other lenders is a great way to ensure that you are truly comparing apples-to-apples for the best deal.

In other words, it may be that that low rate isn’t really as low as it seems because the associated fees drive up the true cost of borrowing those funds. Be careful when making borrowing decisions and be sure to consult a trusted financial professional in order to ensure you are considering all relevant angles.

Read more! Understanding your credit card minimum payments is an important part of truly mastering your finances.

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