In taking a loan you will be face on the word APR more often than you think. What is APR actually?
APR stands for Annual Percentage Rate. APR is an expression of the effective interest rate the borrower will pay on a loan, taking into account one-time fees and standardizing the way the rate is expressed.
In other words the APR is the total cost of credit to the consumer, expressed as an annual percentage of the amount of credit granted. APR is intended to make it easier to compare lenders and loan options.
The APR is likely to differ from the "note rate" or "headline rate" advertised by the lender, due to the addition of other fees that may need to be included in the APR.
In the U.S. and the UK, lenders are required to disclose the APR before the loan (or credit application) is finalized. Credit card companies can advertise monthly interest rates, but they are required to clearly state the annual percentage rate before an agreement is signed.
APR is a term used with regard to deposit accounts as well. However, when dealing with deposit accounts, annual percentage yield (APY) or annual equivalent rate (AER) is the number to be quoted to consumers for comparison purposes.
But how can you work it out and how can you use the APR figure to compare loans?.
In its strictest definition, APR is the expression of effective interest rate you will pay on a loan. It takes into account things such as one time fees you pay.
As a result, it standardises rates and that makes it easier to compare loans. By standardisation (another one of those exciting mathematical/statistical terms) we mean that it tries to ‘make things the same’.
By ensuring that APR includes not only the interest rate on the loan, but also other fees you don’t start comparing loans only to find afterwards that one included arrangement fees and that was the reason it seemed higher, but actually it worked out cheaper!
Unfortunately critics argue that it still isn’t that easy to compare loans based on APR. This is because although APR includes certain fees, it doesn’t include all fees.
Loan companies are only required to calculate compulsory fees into their APR. This means that for example payment protection insurance is not included in the APR.
However, once you take a loan you are very likely to also take out a payment protection insurance for peace of mind.
Some lenders use this for their benefit and advertise a low APR, only to then make additional fees such as the payment insurance protection very high. So that means you can still end uaying more for a low APR loan than for a higher APR loan.
Finally APR does not take into account changing rates. It is only an average of the variety of rates over the whole of your repayment period.
Knowing this can be very handy especially when you are comparing long term loans such as mortgages. You may find that the first 3 years you pay a fixed rate which is significantly lower than the rate you pay for the remainder of your repayment period.
This fixed rate may well vary from loan company to loan company and it would be good to know these rates. However, since APR does not reflect this difference, you cannot make this much of an informed decision based on APR alone.