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Annual Percentage Rate – APR | Is the APR misleading for loans or earnings?

Annual Percentage Rate – APR | Is the APR misleading for loans or earnings?

By Lisa Baker Monday September 6, 2021

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What is an Annual Percentage Rate – APR?

An Annual Percentage Rate (APR) is the annual rate charged for loans or earnings on an investment and is expressed as a percentage that represents the actual annual cost of funds over the course of the year. the term of a loan. This includes any additional fees or costs associated with the transaction but does not take compounding into account. As loans or credit agreements can vary in terms of interest rate structure, transaction fees, late payment penalties, and other factors, a standardized calculation such as APR provides borrowers with a number of bottom-line results that they can easily compare against. fees charged by other lenders.

BREAKDOWN the ‘Annual Percentage Rate – APR’

By law, credit card companies and loan issuers must show customers the APR to facilitate a clear understanding of the actual rates applicable to their deals. Credit card companies are allowed to announce interest rates on a monthly basis, but they are also required to clearly state the APR to customers before signing any agreement. For example, a credit card can charge 1% per month, and its APR is 1% x 12 months, or 12%.

Loans are offered with fixed or variable APRs. A fixed annual rate loan has an interest rate that is guaranteed not to change over the life of the loan or line of credit. A variable APR loan has an interest rate that can change at any time.

APR vs Interest Rate

An interest rate, or a nominal interest rate, refers only to the interest charged on a loan and does not take into account any other expenses. In contrast, the APR is the combination of the nominal interest rate and any other costs or fees involved in obtaining the loan. As a result, an APR tends to be higher than the nominal interest rate on a loan.

For example, if you were considering a $ 200,000 mortgage with an interest rate of 6%, your annual finance expense would be $ 12,000, or a monthly payment of $ 1,000. But let’s say your home purchase also requires closing costs, mortgage insurance, and loan origination fees in the amount of $ 5,000. To determine the APR for your home loan, these fees are added to the original loan amount to create a new loan amount of $ 205,000. The 6% interest rate is used to calculate a new annual payment of $ 12,300. Divide the annual payment of $ 12,300 by the original loan amount of $ 200,000 to get an APR of 6.15%.

The federal Truth in Lending Act requires that every consumer loan agreement include the APR along with the nominal interest rate. The most confusing scenario for borrowers is when two lenders offer the same nominal rate and monthly payments but different APRs. In a case like this, the lender with the lowest annual interest rate is demanding fewer upfront fees and offering the best deal.

APR v/s Annual Percentage Yield

An APR only takes simple interest into account. In contrast, the Annual Percentage Yield (APY), also known as the Effective Annual Rate (EAR), takes compound interest into account. As a result, an APY tends to be higher than an APR on the same loan. The higher the interest rate and, to a lesser extent, the shorter the compounding period, the greater the difference between APR and APY.

Imagine that the APR for a loan is 12%, and the loan is accumulated once a month. If an individual has borrowed $ 10,000, his interest for one month is 1% of his balance or $ 100. That effectively increases your balance to $ 10,100. The following month, 1% interest is charged on this amount, and the interest payment is $ 101, slightly higher than the previous month. If you maintain that balance during the year, your effective interest rate will be 12.68%. The APY includes these small changes in interest expense due to compounding, while the APR does not.

Or, let’s say you compare an investment that pays 5% per year to one that pays 5% per month. For the first, the APY is equal to 5%, the same as the APR. But for the second, the APY IS 5.12%, reflecting the monthly composition.

Another example: XYZ Corp. offers a credit card that charges interest of 0.06273% daily. Multiply that by 365, and that’s 22.9% per year, which is the advertised APR. Now, if you were to charge a different $ 1,000 item to your card each day, and you waited until the day after the expiration date (when the issuer started charging interest) to start making payments, you would have to pay $ 1,000.6273 for each item. what do I buy? To calculate the APY or EAR (the most typical term in credit cards), add 1 (which represents the principal) and take that number to the power of the number of compounding periods in a year; Subtract 1 from the result to get the percentage {(1 + periodic rate) ^ # of periods} – 1. In this case, your APY or EAR would be 25.7% (1 + 0.0006273 ^ 365 = 1.257; 1.257 – 1 = 0.257).

If you only have a balance on your credit card for one month, you will be charged the equivalent annual rate of 22.9%. However, if you maintain that balance during the year, your effective interest rate becomes 25.7% as a result of daily compounding.

Since a different APR and APY can be used to represent the same interest rate, it stands to reason that lenders and borrowers emphasize the most flattering number to make their case (the Truth in Savings Act of 1991 mandated that both the APR such as the APY are disclosed in advertisements, contracts and agreements). A bank will post the APY for a savings account in a large font and its corresponding APR in a smaller font, since the former has a superficially larger number. The opposite happens when the bank acts as a lender and tries to convince its borrowers that it is charging a low rate. A great resource for comparing APR and APY rates on a mortgage is a mortgage calculator.

APR vs Daily Periodic Rate

The daily periodic interest rate is the interest rate that is charged daily on the balance of a loan. It is the APR divided by 365, the number of days in the year. Similarly, the monthly periodic rate is the APR divided by 12. Lenders and credit card providers can represent APRs on a monthly basis, as long as the full 12-month APR appears somewhere before the agreement is signed.

Is the APR misleading?

As illustrated by all of the above, the APR can be a misleading indicator of actual costs. Some experts believe that the APR is best used to compare long-term loans. Even with short-term debt, like a seven-year note, the APR really understates the cost of the loan. This is because the APR calculations assume long-term payment schedules; for loans that pay off faster or have shorter repayment periods, the costs and fees are too low with the APR calculations. The average annual impact of closing costs is much lower when these costs are assumed to have been spread over 30 years rather than 7 to 10 years.

The APR also has problems with adjustable-rate mortgages or ARMs. APR estimates always assume a constant interest rate, and although APR takes rate caps into account, the final number presented to you is still based on fixed rates. Because the interest rate on an ARM is uncertain once the fixed-rate period is over, APR estimates can severely underestimate the actual costs of the loan if mortgage rates rise in the future.

How do credit card companies set the APR?

Most credit cards have floating APRs, commonly called variable APRs. These feature floating interest rates that rise and fall along with the market or an index or the US prime rate. They are established by taking this variable characteristic and adding the bank’s margin to it. For example, if the bank charges a 10% margin and the prime rate is 5%, the borrower pays an interest rate of 15%.

Although they are few and far between, there are also some fixed rate credit cards available. With credit cards (unlike other types of loans), a fixed APR actually means that the rate remains fixed until the lender decides to change it. However, it cannot be changed without prior written notice, and the adjustment only applies in the future on the loan, not retroactively.

In some cases, credit card companies offer different APRs for different types of charges. For example, one card may charge one APR for purchases, another for cash advances, and a third for balance transfers from another card. Similarly, banks charge high-interest APRs to customers who have made late payments or violated other terms of the cardholder’s contract and offer low-interest introductory APRs to attract new customers – preferably those who tend to carry a balance on their cards.

Introductory APRs can have positive effects on personal finances if they are managed carefully. A loan balance of $ 2,000 that has an APR of 12% incurs an interest charge of $ 20 each month. Transferring that balance to a credit card with a 0% introductory APR for 12 months allows you to apply that same $ 20 to the principal, paying off the balance much earlier.

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