When you compare borrowing money from friends or family to
borrowing from a lender, the former seems like a quick and
easy option to get the cash you need at no extra cost. The
essence of borrowing money from your loved ones is trust and
obligation. Still, not everyone may be comfortable
approaching their close confidantes and instead choose to
borrow money from a credit union, bank, or other lenders by
agreeing to pay a pre-decided amount over and above the
principal
amount borrowed.
If you've applied for a loan before or are exploring your
loan options, you might have come across the term Annual
Percentage Rate (APR). The borrowing cost that borrowers pay
when they get a loan, credit card, or another
line of credit
is nothing but the APR. However, there's a lot more to the
concept of APR that you need to understand to make informed
choices about credit. So here are the key things you need to
know about APR before applying for any loan.
What Exactly Is An Annual Percentage Rate (APR)?
The Consumer Financial Protection Bureau (CFPB) defines the
Annual Percentage Rate (APR) as the yearly cost of borrowing
you pay, expressed in percentage value. In the case of
installment loans, the APR usually includes the interest rate, up-front
fees, and other charges for acquiring the loan. This implies
that APR can help borrowers determine the actual cost of a
loan per year.
Different lenders might charge different interest rates and
fees. As a prudent borrower, you should inquire about the
fees included in the APR calculation. Apart from revealing
the actual cost of a credit option, APR can facilitate an
easy comparison between two or more lenders and their loan
options. For instance, if you want to
find the best online loan
for you, APR can help you get a closer estimate of which
loan will cost you the least while offering you the same
loan term
and amount borrowed, and you can make your choice.
How Does The Annual Percentage Rate Work?
The Truth in Lending Act (TILA), a federal law that governs
the calculation and disclosure of APR in the U.S., requires
all financial institutions to use the Annual Percentage Rate
(APR) as the standard measure of interest charges for loans.
In addition, payday lenders have to make the APR available
to all their applicants, but the point is that borrowers
often don't know how to calculate this percentage.
How Is APR Calculated?
Firstly, it is essential to note that the calculation of APR
will be different in the case of credit cards and
installment loans. Although credit card providers charge
annual and late payment fees, these fees do not affect your
APR. For this reason, the APR and the interest rate of a
credit card are often the same. On the other hand, most
personal loans consider different fees like the origination
fee in calculating their annual percentage rate. Late
payment fees are generally not included in the APR of a
loan.
Below is the formula you can use to compute the APR of a
loan that includes fees:
Here's an example of a personal loan to help you understand
how to calculate APR better.
Let's say you borrow a loan of $5,000 with a 5% origination
fee and an interest rate of 7.34%. Though you get $4,750
deposited in your account after deducting $250 upfront as
origination fees, you'll still pay interest on the entire
$5,000. With a repayment term of two years, your APR based
on the above formula will be 11.87%. You can see that the
APR is higher than the interest rate due to the additional
cost of the origination fee.
It's also important to note that the annual percentage rate
in the above example is the same throughout the entire term
of the loan. However, not all APRs remain constant
throughout the loan term. Your APR may also increase if you
pay off your loan early or choose to
refinance your personal loan. This brings us to the two main types of annual percentage
rates.
What Are The Types Of APRs?
Your installment loan can either have a fixed or variable
APR. Whether your loan has a fixed or a variable APR can
significantly affect the cost of borrowing. Hence, you
should know what each type of APR entails to help you find
the right online loan to suit your budget.
Fixed APR
As the name suggests, fixed APR doesn't change during the
loan
tenure. This helps you to have a fair idea of your monthly
payments, which in turn makes budgeting easier. Fixed APRs
are most common in the case of mortgages and personal loans
rather than credit cards.
Variable APR
When your APR changes due to the fluctuation in the market
interest rates or your
credit score, it means you have a variable APR. Usually, you'll find
this type of APRs for credit cards, but there are
installment loans that have variable APRs too. For this
reason, you should check the type of APR applicable to your
loan before applying with your lender. Needless to say that
budgeting with a variable APR can be challenging.
Apart from fixed and variable APRs, you will find many
different kinds of APRs, mainly associated with credit cards
or lines of credit. They are purchase APR, balance transfer
APR, introductory APR, cash advance APR and penalty APR.
Most of them are based on the purpose of using the credit or
how you choose to use the credit. You can check with the
lender for more clarity on the APR applicable to the loan.
What Factors Influence the Annual Percentage Rate?
Once you find enough information on the type of APR when you
take out a loan or a credit card, you should consider the
factors that can affect the annual percentage rate offered
to you.
Some of the common factors that influence your APR are:
Creditworthiness
Many lenders decide your APR after reviewing your
credit history
and credit score. Lenders being lenders will always consider
your ability to repay the borrowed amount and might offer a
loan with a higher APR if your credit history shows that
you've missed several payments before.
Debt-To-Income Ratio
The ratio between the amount you owe to your monthly income
is called the
debt-to-income ratio
(DTI). You might have a good and stable income, but you
might be spending a large portion of your monthly income on
debt payments. Your lender can charge you a higher APR or
reject your application if you have a high DTI.
Fees And Other Costs
Since interest and fees combine to form your APR, you might
have a higher annual percentage rate if a lender charges
hefty fees when taking out a loan. To avoid paying more than
anticipated for a loan, check the loan's terms and
conditions for any hidden costs before signing your
loan agreement.
Prime Lending Rate
As opposed to all the other factors affecting APR, the prime
interest rate is the reason you see fluctuations in your
variable APR during the loan tenure. Influenced by the
Federal Reserve's federal funds rate, the prime rate changes
every time the Federal government adjusts interest rates
throughout the country.
Type Of Loan
Secured loans
typically have lower APR than unsecured ones. Using
collateral reduces the risk of the lenders as they have a
right to sell the asset in case of a default. With low APR,
secured loans are also believed to be easier to qualify for,
even with a poor credit score.
As a little tip, you can
pre-qualify for a personal loan
to know the APR you will likely receive. If the annual
percentage rate is higher than expected, you can move to the
next best loan option or work to obtain a lower APR.
How To Get a Low APR Loan?
Now that you know the factors that can affect the annual
percentage rate, you can take a cue from it and make efforts
to lower your APR. Since regulating the prime rate is not in
your hands, you can begin by
boosting your credit score
and reducing your debt-to-income ratio. You can't get a good
credit score or DTI overnight. You will have to avoid late
payments, exceeding your credit limit, and other things that
can negatively affect your credit. Paying off your debt and
increasing your monthly income could help lower your DTI.
You can refinance your high-interest loan with a lender who
provides lower interest rates and reduce your overall loan
cost.
Though it is hard to define a good APR in terms of a loan,
you can always try looking for a loan with an APR that
doesn't put your finances into trouble. Conversely, zero is
the best APR a credit card can offer. Credit card providers
usually offer 0% APR as a promotional offer to their new
customers.
The Final Say
If you're planning to borrow funds, understanding what APR
means, how it works, and the factors affecting APR can help
you better manage your finances. In addition, knowing
whether your loan has a variable and fixed APR can enable
you to
create a smarter budget. Above all, annual percentage rates are one of the main
criteria you want to consider while selecting the right
credit option.
You should find the APR mentioned in your loan agreement.
CASH 1 adheres to the Truth in Lending Act and is
transparent in its operations. We work with our clients to
explain the total cost of its various options, so applicants
can choose which loan best suits their financial needs.