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
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
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:
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
- 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
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.