What is APR – Annual Percentage Rate

annual percentage rate (APR) signAPR is the acronym for several terms, but here we’re referring to it as the acronym for Annual Percentage Rate. In simplest terms, APR means the annual cost for the privilege to borrow money.

Financial firms offer to lend money and then charge a fee for doing so. The rate charged can vary for each borrower based on how confident the firm is that they will pay them back and what their credit score is. The amount actually paid can also change based on how it is calculated under the agreement.

There is almost always an APR associated with an auto loan, credit card, or home mortgage, all of which we will cover in detail below.

Credit Cards

The APR associated with credit cards is generally the most straightforward.

When thinking of a 20% APR on a standard credit card, you divide it by 12 to roughly get the rate that will be applied to your balance monthly (approximately 1.67% in this case).

.20 / 12 = 1.67%

This rate can be charged as a fixed APR or as a variable APR.

Fixed Rates
A fixed rate is what it sounds like- a rate that is fixed during the charge period.

Variable Rates
Variable on the other hand is tied to a published rate, often the US Treasury Bill Rate or Prime Rate. As an example, the rate will be expressed as “prime rate + your rate”. This is updated at set increments, even daily in some cases. Although variable-rate cards often offer lower introductory rates, they can also cause trouble for consumers if the rate resets too high for them in the future.

Calculation Methods

The calculation using the APR, fixed or variable, can change from company to company and card to card:

Average Daily Balance
The credit card company averages your daily balance throughout the month. Specifically, they look at your balance each day and divide that by the number of days in the month. That amount, multiplied by approximately 1/12 your APR, would equal the finance charges for the month.

Daily Balance
Using this method, companies calculate the finance charge based on your outstanding balance each day. This daily amount is multiplied by approximately 1/365th of the APR to determine the daily finance charge.

Two-Cycle Balance
This method is the most expensive. Here, the company charges interest on debt already paid. They take the average daily balance over the past two billing cycles and charge interest on it. The bad thing is that extra payments made to reduce your balance won’t affect the previous balance, so you’ll have to pay a higher rate, even after reducing your balance.

Previous Balance
Companies issue a statement showing the balance at the beginning and the end of the month, and charge interest on the beginning.

Loans

When constructing an APR for a loan, there are several related costs and fees included that are required to originate the loan. These are left to the discretion of the lender. The formula varies from institution to institution depending on the type of product and length of the loan – there is no official standard as of yet. Some fees cannot be predicted in an APR such as an early loan payoff fee, late payment fee, or fees incurred if you refinance the loan.

In 2008, an amendment to the Truth In Lending Act states that if the final APR is off by more than .125% from the initial disclosure, the lender must notify the borrower within three business days before closing on the transaction. There are also many reform bills passed over the years that have changed the disclosure process and place interest limits and other regulations on financial institutions. Credit laws also vary from state to state.

So, when you see an APR advertised, what you’re looking at is the percentage per year you will be paying on the amount of money you borrow. APR is a good starting point for comparison, but depending on the amount of the loan and length of time you will be borrowing the money, a closer examination of the fees involved would be prudent. Another factor to consider is whether the money is compounded daily or monthly as this will make a significant difference in the total amount you will be paying.

Auto Loans (other bank loans)

The APR can be even more deceptive and confusing when financing or leasing through an automobile dealership or vendor financing. A markup on a vehicle can in fact be hidden in the APR making the metric meaningless as a point of comparison. This is actually a common practice when financing through a car dealership.

Say an automobile is leased (or sold) to a customer at the manufacturer’s suggested retail price and at a low APR. The dealership will in fact accept this lower lease rate in exchange for a higher sales price. The customer has received cheap financing in exchange for a high purchase price. If the customer had self-financed, the dealer would have accepted a lower sales price.

In short, this makes the advertised APR meaningless as it understates the true cost of the financing. The only way to find the true APR would be to determine the lowest acceptable price for the vehicle, arrange the financing yourself, then go back to the vendor and compare their financing terms.

The process gets even more muddied when there is a trade-in involved or the lessee has a purchase option at the end of the lease and the value of this option is not transparent.

Mortgage Loans

Mortgage loan financing is more complicated but not nearly as shady as the aforementioned financing vehicles. As stated above, the fees that are included in an APR for mortgage purposes vary between institutions and are subject to change through legislation but in general, the following fees are involved in a typical home mortgage and relevant to the APR.

  • Origination fees
  • Loan processing
  • Underwriting and document preparation
  • Closing agent’s document preparation fees
  • Private mortgage insurance (PMI)
  • Attorney and notary fees
  • Pre-paid interest
  • Points

Sometimes included:

  • Life insurance
  • Application fees

Generally not included:

  • Credit report costs
  • Home inspection
  • Appraisal
  • Title fee

In summary, the annual percentage rate (APR) is generally a good measurement of cost when shopping around for financing of one form or another. However, it is not the only thing you should be looking at once you have narrowed down your choices, because it can often get confusing and may be slightly misleading.

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Posted on July 1, 2020 by in Personal Finance

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