What is APR and Why Should You Care?
September 21, 2016Ever wondered what promotional ads for loans mean when they talk about APR and more importantly, why you should care? Well, you should care and the answer comes from Teig Stanley, one of my brilliant CFP® colleagues who has perhaps the most diverse career experience on our team. He started his career as a child actor, has lived all over the world, and most relevant to this post, he was involved in the mortgage industry before we were lucky enough to hire him to the Financial Finesse Planner Team. Here’s what he has to say:
First of all, APR stands for “annual percentage rate.” It is the actual annual cost of any loan, including mortgages, car loans and even credit cards, expressed as a percentage of the total loan amount, including interest AND fees. It must be disclosed in nearly all consumer credit transactions according to Consumer Finance Protection Bureau regulations.
For example: If you took out a five-year $1,000 loan with no interest or fees, you’d simply divide the total loan amount by five years to arrive at a payment of $200 a year. Since there is no interest or fees, the APR is 0%. Let’s imagine that the loan has a simple interest rate of 5% but no fees. Each year, you would pay $200 (principle) plus 5% of the loan balance ($50 the first year, $40 the second year, $30 the third, etc.) That 5% is a cost for you, so in this case, the APR would be 5%.
Now let’s say there was a one-time $100 fee for the loan (sometimes called an origination fee). That would make the APR 7% – higher than the interest rate because it is taking the total cost into account. Finally, imagine that the interest is compounded. In the first year, you not only owe $200 in principle, $100 in fees, and $50 in interest, but you also owe 5% on the $50 in interest that has accrued during the year (an additional $2.50). While this amount is small, it does add to the APR, making it 7.0024%.
Confused? Don’t worry. Any bank that is offering a loan must disclose the APR so they already do this math for you.
But it’s important to pay attention to the APR because if you are expecting a simple interest loan (no fees or compound interest), you can actually confirm that by checking the APR. It should match the interest rate. If it doesn’t, that’s a red flag that something is wrong. In most cases, the APR for a loan is going to be higher than the interest rate because of fees and compound interest.
So one way to compare two loans with the same interest rate would be to compare the APR on those loans. A higher APR for one indicates that the fees or compounding would cost you more over time. It’s quite common for lenders to advertise super-low interest rates to get you hooked, only to have you discover that that they will make up for the lower interest rate with fees. Checking the APR allows you to spot these tactics and avoid paying more than you would with a higher rate but no fees.
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