Definition of APR
APR is an acronym for Annual Percentage Rate
APR is an acronym for Annual Percentage Rate, the effective rate of interest that a borrower will pay on a loan on an annualized basis. The effective annual interest rate that a borrower will pay includes not only the stated rate of interest, but also includes compounding effects and likely also includes other fees that any borrower is able to add to the total repayment amount for any loan. The purpose of APR is to provide the borrower with a means of comparing the true cost of borrowing so that he can make the best choice for himself and his situation.
An Introduction to APR
Assessing loans solely on the basis of the nominal interest rate charged for the loan can be deceptive, leading the borrower to believe that he is paying much less for the loan than he actually will be repaying in total. Though the periodic rate – such as 3 % per month – actually is 3 % per month, the annual rate is not the 36 % that one might expect it to be, given that the borrower is paying 3 % each month for a total of twelve months in a year.
Rather, the effective annual rate will be 42.57 % without any additional fees that also need to be considered in calculating total APR. The reason for the discrepancy is that when interest is compounded, the borrower then is paying interest on interest.
How can that be?
For a loan that requires monthly payments, the first month includes interest on the full amount. The borrower makes a payment, which is deducted from that full amount.
The periodic interest rate is then applied to the new balance, which now includes an amount for interest charged in the first month.
The net effect is that the borrower is paying interest on interest, which has a significant effect on the total of payments required to completely repay the loan. Where lenders charge other fees such as with mortgage loans, the effective APR can be much higher than the borrower might expect. The APR produces a bottom line true rate of interest so that borrowers can make intelligent financing decisions for themselves and their needs.
Calculating APR
APR is not difficult to calculate. It is determined by putting the nominal interest rate (i) and the number of payment periods in a year (m) into this formula: (1+ i / m)^m -1. For a credit card account or for a mortgage, m will equal 12, for one payment each month for a year.
This can be merely academic exercise in some areas, such as when dealing with a credit card issuer that does not take every legal opportunity to apply additional fees. Though a “fee” is not “interest,” it nonetheless adds to the total cost of any loan to which it is applied. Anything that increases the cost of the loan also increases the effective rate of interest that the borrower pays. That translates to a higher APR.
APR and Credit Cards
A mortgage lender typically adds several fees to the total amount being mortgaged, thereby increasing the true amount of the loan. Because the borrower pays interest on interest, increasing the amount of the loan at the beginning also increases the APR that the borrower will be paying. The same is true for other kinds of loans where lenders are known for adding on one or more fees.
A payday loan is an example, although a dramatic one.
If a payday loan lender charges £20 or £30 for a payday loan of £100 that is due in two weeks, there is no stated interest rate.
Only the “fee” is discussed, but the APR – which the lender must disclose to the borrower – can be 800 % or more.
One reason that the APR jumps so dramatically is the doubled number of payment periods included in the APR calculation.
Instead of the 12 months used in the example calculation above, a payday loan based on a two-week repayment has 52 ÷ 2 = 26 periodic payments affecting the APR calculation.
Credit cards typically are more straightforward in the APR calculation, however.
The card issuer that charges no annual fee for the privilege of carrying the card can calculate its APR as in the example above. Card issuers that charge an annual fee, a usage fee, a non-usage fee or any other kind of fee also must include those fees in their APR calculations.
All card issuers must also provide the APR specific to their credit card products. The purpose of the APR requirement is to ensure that borrowers have the information they need to make sound financial choices, so credit card issuers must include all influencing factors in the APR figures that they provide to their customers.
APR and Buy Now Pay Later
The Buy Now Pay Later option can be a good one to use if the borrower is disciplined. In the Buy Now Pay Later arrangement, a retailer extends promotional credit for some stated period of time, such as six, nine or twelve months. If the borrower pays the principal in full before the end of that stated period, then he pays no interest at all on the amount financed. If he fails to repay in full before the end of the promotional period, however, then he will owe interest on the entire time back to the date that he entered into the agreement.
As an example, a clothing store offers a Buy Now Pay Later offer of no interest for six months if the total is paid within those six months.
If the borrower fails to pay the full balance in that length of time – which generally is the case – then at the beginning of month seven he / she owes interest for all six months as well as the unpaid principal balance. The APR for one such current offer is 39.7 %.
Not many shoppers actively seek interest rates such as 39.7 %. It is the promise of paying no interest at all that leads many to act and to enter into the agreement with the retailer. The agreement is to the shopper’s benefit if he is disciplined and pays the full amount before the end of the promotional period, but it is the retailer that gains the greatest benefit if the shopper fails to plan carefully.