Use APRs to Make Good Loan Decisions

To understand Annual Percentage Rate, you must first understand principal and interest. The principal is the amount of money you borrow for a loan. Interest is money on top of the loan amount, that you pay to the bank to compensate them for lending that money to you. Interest is a percentage of the loan amount, is a regular payment usually charged monthly or annually, and is paid for the duration of the loan. For example, on a loan of $200,000 with an interest rate of 5%, annual interest would be $10,000, possibly decreasing as the principal is paid down. The interest rate is often clearly listed on a loan product, and for most people, this informs their decision to borrow money. However, your decisions are better informed when you review the fine print before you borrow from a bank.

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Look at your loan documentation, and you will find the APR listed beside the interest rate. The Annual Percentage Rate is different from the interest rate. It includes fees, such as loan establishment fees, loan discharge fees, and account administration fees, as well as the interest charges. Establishment and discharge fees are not charged every year but only at the beginning and end of the loan. The APR averages out all the costs of the loan and provides an annual rate. When you compare the interest rate and the Annual Percentage Rate, pay attention to how similar or different the two rates are. A big variation indicates the loan includes numerous "junk fees."

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Imagine you approach two different banks to borrow $200,000 for five years. They will likely quote you different interest rates and different fees. Bank A quotes you a 5% interest rate and no fees. The total cost of this loan is $50,000, comprised of $10,000 of interest per year for five years. Bank B quotes you a 4.5% interest rate and a $6,000 establishment fee. The total cost of this loan is $51,000, comprised of $9,000 of interest per year for five years, plus the $6,000 fee at the beginning. If you look at interest rates alone, you will borrow from Bank B, but the APR shows the total cost of the Bank B loan is higher.

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APRs are a complication to calculate. Do not try to do it yourself. Your bank will tell you the APR for your loan. Rather than attempt to calculate the APR, you can compare options using an online mortgage calculator. APRs should only be used to compare identical loans. Ask the bank to quote their APR using the same fixed or variable rate, the same loan term, and the same loan type. It does not work to compare oranges with apples. The loan with the lower APR will cost you less and is the better option.

The APR averages cost over the full length of a loan. For a home loan, this is generally 25 to 30 years. Often, home loans are repaid or refinanced in a shorter timeframe. Assume you refinance your mortgage after five years. Utilizing the APR might skew your decision as to which loan to use. The APR creates an average, so it spreads the cost of upfront fees over the 25 to 30 year period. Repaying your loan in five years throws out this calculation.

The APR treats interest as though it is paid annually. If you think back to your past loans, you'll likely remember this is not usually the case. Loans generally apply compounding interest, which means they charge interest on both the principal and the interest accumulated to date. When compounding interest applies, the more frequently interest is charged, the higher the overall cost of your loan will be.

The Effective Annual Rate (EAR) takes into account compounding interest. Like the APR, the EAR incorporates interest, fees, and charges. Unlike the APR, the EAR also considers the timing of the charges. For example, the EAR includes the extra accumulated interest over the year when the lender charges interest on a more frequent basis, such as monthly or quarterly. It also measures the effect of compounding interest on upfront fees. The EAR is sometimes called the annual percentage yield (APY). Likely, it is referred to as the EAR when you are borrowing and the APY when you are lending or investing.

You should review the APR when you invest money as well as when you borrow to reveal hidden costs and charges included in the financial product. Once again, if there is a large amount of variation between the interest rate and the APR, this indicates the financial product has excessive fees. Review the APY to see how compounding interest impacts the return you receive from your investment. The more frequently interest is paid, the higher your returns will be.