Small Business Financing Blog

The ABC's of APR's: How the Annual Percentage Rate Measures the True Cost of a Loan


At its most basic level, an Annual Percentage Rate (APR) is generally defined as the “current cost of borrowing.” Most would agree, though, that this definition is not terribly helpful in its attempt to explain the meaning of an Annual Percentage Rate . Fortunately, there are other definitions. For instance, an Annual Percentage Rate is also a financial reflection of the total interest costs on a mortgage loan –averaged across the loan’s full term. APRs are best suited as a comparative financial tool to be used when shopping for a loan or a mortgage. This is because the APR reflects costs, fees, as well as interest rates. Read on to learn how the annual percentage rate measures the true cost of a loan.

An Annual Percentage Rate provides a more in-depth, detailed financial perspective than interest rates offer. In theory, APR’s are designed to help borrowers avoid comparing apple-loans with orange-loans. And while the Annual Percentage Rate accomplishes this goal, the APR can also be a misleading financial concept, if improperly analyzed. The reality is, this happens, too often.

If each lending institution charged the same fees and costs on every loan across the country, the APR could potentially be used as a consistent comparative calculation with a reliable benefit. The reality is, different lenders have the option to choose which fees to include in their Annual Percentage Rate calculations, and have the option to omit others. As such, loan costs vary significantly from lender to lender which essentially reduces the reliability of the Annual Percentage Rate calculation as a comparison tool.

APRs are Complicated, But Not Insurmountable

Remember, lending is fundamentally based upon risk. Risk is the financial concept that is the basis for how the annual percentage rate measures the true cost of a loan.

What Causes the APR to Fluctuate?

Several factors impact the movement of an Annual Percentage Rate . The following factors impact how the annual percentage rate measures the true cost of a loan.

The Loan Type/Product

Certain loans have more expensive loan fees. Loans that are collateralized (secured by a home or automobile, etc.) have demonstrated themselves to be les of a risk to lenders. Borrowers tend to pay their secured loans before their unsecured loans. Therefore, auto and home loan rates are typically lower than their unsecured counterparts, like credit cards or personal loans.

The Borrower’s Credit Profile

A borrower’s credit worthiness is defined by their credit history. The best predictor of someone’s future financial behavior is the person’s past financial behavior. Those who show, over time, a willingness and ability to their debts on time will likely receive reduced APRs on future loans.

The Borrower’s Loan Payment Ratios

Comparing the loan’s payment to the borrower’s monthly income calculates the borrower’s debt ratios. For example, if the loan’s monthly payment is $100 and the borrower earns $2,000 per month, what would you calculate the debt ratio to be?

Luckily, the calculation is basic grade-school arithmetic.

Payment: $100

Income: $2,000

Debt Ratio: 100/2000 = .05 or 5%

In the mortgage industry, there are technically two different debt/income ratios. The first ratio reveals the Debt Ratio for monthly housing expenses when compared to monthly income. The second ratio includes the borrower’s housing expenses plus, all other debt; like credit cards, car loans, etc.

From an underwriter’s perspective, the lower one’s debt ratio, the less risk is associated with that potential borrower. Good ratios verify that the borrower is not being too aggressive with their borrower goals.

More Refined Details About Annual Percentage Rates

Before you actually apply the APR as a comparison tool, it is critical to understand a few significant things regarding the concept of the APR.

  1. Credit Cards and APR’s

The Annual Percentage Rate reveals the interest rate a credit card user will pay, should they pay the entire balance off each month. It is important to note that the APR calculation for a credit card excludes the effects of compounding interest. Credit card users, who choose to make minimum payments, will eventually be paying interest on interest (the compounding effect); something to be avoided at all costs. The effects of compounding interest increase borrowing cost sharply.

A credit card APR only accounts for interest costs. So, when researching which credit card is best, you must also compare lender fees separately. In some cases, how you plan to use the card will be the deciding factor when comparing APRs. And if that is not enough, the same credit card might have several different APRs which are based upon whether the transaction, is a balance transfer, a purchase or a cash advance.

  1. Mortgage Loans and APR’s

From a mortgage perspective, the Annual Percentage Rate is more complex because the APR includes your interest charges and costs. As noted previously, lending institutions have the ability to choose which fees will be included in the Annual Percentage Rate calculation. When it comes to mortgage loans, a potential borrower must evaluate the APR as well as many specific issues associated with mortgages. Mortgage loan APR’s are traditionally impacted by the mortgage loan’s Loan-to-Value (LTV).

  1. How Long A Borrower Intends To Take To Pay Back Their Loan Impacts the Annual Percentage Rate

The length of time you intend to use the loan funds is an important facet of anyone’s loan decision. A large up-front fee will increase the cost of your loan, but the Annual Percentage Rate will calculate the loan costs over the life of the loan/mortgage. If you intend to keep the loan for a minimal amount of time, the actual APR is inherently higher. For loans paid off quickly, it is noted that the APR quoted tends to undervalue the influence of costs paid at closing.

How the Annual Percentage Rate Measures the True Cost of a Loan (when the initial APR is 0%)?

A zero percent APR suggests that there is no interest charged for the monies borrowed. Borrowing without any interest costs, is simply ‘too good to be real.’ Take note, though, zero percent APR loans seldom last for very long.


Should you need additional information, insight or clarification, please visit our comprehensive financial website more often. We’re dedicated to providing the most current information regarding the small business lending industry, including updates on available business financing programs. LenCred offers a variety of useful resources and tools to commercial entities. LenCred’s ethos is best described as a financial hub that helps business owners sort out financing options for countless business purposes.

 


2 thoughts on “The ABC's of APR's: How the Annual Percentage Rate Measures the True Cost of a Loan”

Thank you so much, this was really helpful. I’m currently doing a merit badge for Boyscouts and this really helped.

Brittni Abiolu

Hi Johnathan! I am very happy to hear this helped you. Please come back to visit the blog soon! Thanks.

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