What is annual percentage rate (APR)?

Introduction

APR stands for the Annual Percentage Rate of charge. It is a good tool to use to compare different credit and loan offers, even when the structure of the loan is different. It is by no means the only important figure and therefore matter for consideration in choosing a loan, however, it is a very important one.

This article explains why getting the right APR for you is so important and how it can save you money.

Background

All lenders have to tell you what their APR is before you sign an agreement. 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 agreements. Credit card companies are allowed advertise interest rates on a monthly basis (e.g. 2% per month), but are also required to clearly state the APR to customers before any agreement is signed. For example, a credit card company might charge 1% a month, but the APR is 1% x 12 months = 12%. This differs from the annual percentage yield, which also takes compound interest into account.

Why does it matter?

The APR rate of a loan is a very useful number because it helps you compare the cost of different loans. Usually, the higher the APR on a loan, the more you'll have to pay (assuming that all other things are equal). The APR does not include all the costs of a loan, but it tells you about the most important one.

If you are looking around for a loan, you usually want as low an APR rate as possible. However, you should also be on the look out for other costs, such as administration fees, legal fees or penalties should you decide to pay off the loan early.

The following factors can affect the APR:

• How you repay the loan;
• The length of the loan agreement (or term);
• The frequency and timing of instalment payments;
• The amount of each payment;
• Certain fees associated with the loan; and
• Certain compulsory insurance premiums (for example payment protection insurance).

The APR will vary from lender to lender. Generally, the lower the APR the better the deal for you, so if you are thinking about borrowing, shops around.

Here is how it works:

Example 1:

If you borrow £1,000 for one year at 20% interest, and at the end of the year you repay a lump sum of £1,200:

You will be paying an interest rate of 20%; and

The APR will also be 20%.

Example 2:

If you borrow £1,000 for one year at 20% interest, and pay throughout the year in equal monthly instalments (12 x £100 = £1,200):

You will still be paying an interest rate of 20%; but

The APR, however, will be roughly 40%.

Example 2 Is more expensive because you are paying back the £1,000 gradually throughout the year. In Example 1 you have the benefit of being able to access the £1,200 for the whole year, which you could invest and earn interest on. By paying in instalments you're losing out; this increases the cost of the loan - hence the higher APR.

The following fees are generally included in the APR:

• Points - both discount points and origination points;
• Pre-paid interest – this is the interest paid from the date the loan closes to the end of the month. Most mortgage companies assume 15 days of interest in their calculations. However, companies may use any number between 1 and 30;
• Loan-processing fee;
• Underwriting fee;
• Document-preparation fee ;
• Private mortgage-insurance;
• The following fees are sometimes included in the APR;
• Loan-application fee;
• Credit life insurance (this is insurance that pays off the mortgage in the event of the borrowers death).

The following fees are NOT normally included in the APR:

• Title or abstract fee;
• Escrow fee;
• Attorney fee;
• Notary fee;
• Document preparation (charged by the closing agent);
• Home-inspection fees;
• Recording fee;
• Transfer taxes;
• Credit report;
• Appraisal fee.