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Don't be fooled by APR number

The term "APR" is supposed to give consumers an easy way to compare loan offers, but if you use it as your only method of comparison you'll probably end up with the wrong loan.

Confusing? Let's back up.

The federal Truth in Lending Act requires lenders to disclose the APR -- annual percentage rate -- on every loan, so consumers can have a single number to use in comparing loan offers.

And it works: APR is computed by including the rate of interest on the amount borrowed plus the amount of the fees you have to pay to get that loan. The higher the APR, the more you will pay over the life of the loan. It shows the total cost of the credit extended to you, expressed as a percentage of the amount of the credit.

It's designed to be used only to make comparison, not necessarily to show how much interest you're paying over the course of a year. In many cases there is little difference between those two things, but in some cases the difference can be significant.

The true interest rate you pay on your loan is called the "nominal" rate or the "stated" rate or the "headline" rate.

If there are no fees charged, the APR and the note rate are the same. Adding in the fees makes the APR -- also known as the "effective" rate -- higher.

Let's consider a few very simple examples:
Loan No. 1 Loan No. 2 Loan No. 3
Amount: $1000 $1000 $1000
Term: One year One year One year
Stated rate: 7 percent 7 percent 7 percent
Fees: $0 $100 $200
APR: 7 percent 25.279 42.685
Monthly payment: $86.53 $86.53 $86.53

These examples -- while not typical of a real-world loan because the fees are excessively high for the amount borrowed -- nevertheless help demonstrate the effect fees can have on APR and how a consumer can use the APR figure to compare loans.

All three loans appear similar at first glance. But the fees make them vastly different. Before you start to howl and point out that in Loan No. 3, for example, $200 in fees is only 20 percent of the amount borrowed and therefore the APR cannot possibly over 40 percent, keep these two important facts in mind:

  • In Loans 2 and 3 the net proceeds of the loan are $900 and $800 respectively.
  • Unless you have an interest-only loan, the loan balance will be paid down through the course of the loan so the actual balance you are paying interest on decreases each month. This actually causes the APR to increase in shorter term loans. Think of it like this, if you have a loan that starts out at $1,000 that is paid off in one year, your average balance for the year will be closer to $500.00. So, if you have $200 in fees that need to be paid over 12 months and the average balance is $500 the fees alone will equal about 40 percent.

This is probably the most frequent way unscrupulous lenders get away with extreme fees and rates. When a loan is being "amortized," meaning the outstanding balance is being reduced over the term of the loan, you cannot simply average the fee out as if the balance remained constant over the year. So a $200 fee seems like 20 percent when it is more like 40 percent. A $100 fee seems like 10 percent when it is really 20 percent.

3 times when APR can mislead
APR can steer you into a more expensive loan than you might otherwise. You should NOT use APR to compare loans in these situations:
The loans are for different periods of time
The loans have different rate-point combinations
You plan to refinance before the loan term expires

Again, you need to base your calculations on the declining balances of the loan, not assume the balance remains constant. If you borrowed $1,000 and didn't pay any of the principal back until the end of the year, the $200 in fees would represent 20 percent.

Other variables
APR is even more useful when you try to compare loans when there are variables other than the amount of fees. All the examples above are calculated with the assumption the fees are going to be paid out of pocket and not included in the loan amount.

Let's say Loan No. 4 was advertised at only 5 percent, but with $300 in fees required. An interest rate 2 percent lower may sound like a great deal. The monthly payments would be lower, at just $85.61, but the new APR would be 73.051.

Next: "... APR is better than a sharp stick in the eye, but that's about it."
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