You may have heard the saying “there is no such thing as a free lunch” —so, it should come as no surprise to you that everything has a cost. The pertinent question in most situations is: what is the cost? It’s not always easy to tell!
When it comes to borrowing, the Annual Percentage Rate (APR) is one tool that helps you measure and compare the cost of different loan products. Think of an APR as the comparative “price tag” for your loan (paging Jessie J!).
APRs can be very helpful in trying to understand your best “borrowing” deal, but it is also important to understand what an APR is and isn’t, what an APR does and does not tell you, and the limitations of an APR calculation when making your credit decisions. There are many misconceptions about APRs, and the following three facts may (OMG!) surprise you.
1. APR and Interest Rates are Not the Same Thing!
Some people use APR and interest rates interchangeably. Here’s a great way to be the brainiac at your next virtual cocktail party – simply explain that they are not the same thing. Here’s how: “Yes, darling, it’s true that interest rates and APRs are both expressed as percentages – simply everyone knows that! However, the two are not always the same! In general, APRs will take interest into account, but may also include other fees as well. Oh, these cocktail weenies are divine!”
Once the party is over, digest some of these sobering facts: In addition to interest, APR will always include transaction fees, loan origination fees, consumer points, credit guarantee insurance premiums, and mortgage broker fees. Depending on the specific situation, an APR may include other types of fees as well. APR takes interest and all these fees and expresses the whole kit and caboodle as a nominal yearly rate.
Because APR is more inclusive than interest rate, it may be more helpful in determining your total cost of a loan.
Example: You have found a killer deal on a 1962 Ford Thunderbird and cannot wait to take it home. However, first thing’s first—you need to secure financing. You obtain auto loan quotes from two banks, My Money Valentine Bank and Cash Me If You Can (CMIYC) Bank.
- My Money Valentine Bank offers you a $10,000 loan for a 72-month term at an interest rate of 10%, with no other fees.
- CMIYC Bank offers you a $10,000 loan for a 60-month term at an interest rate of 8%, with a $1000 transaction fee. (Since there is a $1000 upfront transaction fee, and you want to walk away with $10,000, your actual loan principal here would be $11,000).
Which loan is cheaper? Which loan do you pick? They’re pretty hard to compare, since they have different interest, fee structures and other terms. APR to the rescue!
The Truth in Lending Act requires that most consumer lenders disclose their terms and costs in a standardized manner, which includes the APR. From your loan documents, you can see that My Money Valentine Bank’s loan has an APR of 10%, and that CMIYC Bank’s Loan has an APR of 12.08%.
So—get this— even though My Money Valentine Bank offered a higher interest rate, its loan actually has a lower overall cost as a nominal yearly rate. That’s a reason to laugh all the way to the bank!
2. APRs for Short Term Loans May Seem High, But They Need to Be Taken in Context
Now you may have noticed that not only does an APR help you compare loan products with different interest and fee structures, they also seem to depend on when the loan is scheduled to be repaid. Aren’t you the smart one!
The “A” part of APR stands for “annual”—APRs express the cost of money borrowed as an annualized rate. In other words; APR operates as if the loan term is exactly one year (regardless of whether it is actually shorter or longer). As a result (and in general), loans with longer terms will have lower APRs and loans with shorter terms will have higher APRs – all other things being equal. However, in terms of the actual dollars paid, a long term loan (although carrying a low APR) could be extremely costly, and a short term loan (although carrying a high APR) could be very reasonable.
Example: Imagine this—COVID 19 is over, and movie theaters are open again (who knew we would all miss the movies so much?!) You and your best friend are excited to watch the newest Marvel film. Of course, you can’t watch a superhero movie without refreshments, but when you reach the concession stand, you realize that your phone’s battery is dead. This is definitely not a super development because you were planning on paying with your Apple Wallet. Luckily, your friend plays the superhero by fronting you with $17 for your extra-large popcorn, covered in liquid butter, M&Ms, and soda, saying, “That’s what friends are for!” The next time you see your friend, you pay her back with a $20 bill, saying, “Keep the change.”
- Let’s consider this a loan: a $17 loan, with $3 of “interest,” paid back in 7 days. Sounds reasonable, right? But the APR would be 920.16%!
The APR seems very high because the loan is short-term (seven days), but the fact of the matter is you didn’t pay a huge amount in terms of the actual dollars spent to munch your way through your new favorite movie—how Marvel-ous!
In the same way, a payday loan may have a higher APR (because it is paid back within a short amount of time) but the fees might actually be quite reasonable. For example, compare Loan A and Loan B:
- Consider a payday loan of $100, with a one-time $15 finance charge, with a loan term of 14 days. The APR is approximately 391%.
- Consider a credit union personal loan of $100, with an interest rate of 36%, and a loan term of one year. The APR is 36%.
Although the APR for the credit union loan (36%) is much lower than the APR for the payday loan (391%), you will actually end up paying more in fees on the credit union loan than for the payday loan! Specifically, for the credit union loan, you will end up paying $36 in fees at the end of the year. Compare this with the $15 fee for the payday loan. This goes to show that when analyzing APR, loan terms matter—a lower APR does not always mean a cheaper loan in terms of actual fees paid. Save the day and be your own savings superhero by always considering the amount of the total payments in addition to APR.
3. Some Everyday Costs May Have Shockingly High APR Equivalents
What is a “high APR”? The answer is that it depends on the context of your situation. For example, a payday loan with a 391% APR may seem high, but everything is relative. Consider the following scenarios:
“Uh Oh, Who Turned Out the Lights?”
- It’s been a tough month—you have had to spend all of your savings on your dog’s vet bill, so you don’t have enough left over to pay your $100 utility bill. The city’s utilities department charges you a late fee of $25, and disconnects your utilities for non-payment. Five days pass before you are able to make your payment, and then they hit you with a $50 reconnect fee! Ugh. At least Fido is doing better though—he is the light of your life after all, despite not currently having actual lights in your house. If this were a loan, the APR would be 5,475%!
“It’s in the Lease!”
- You pay your $915 rent for your apartment via check, but forget that your checking account only has $800 in it due to buying a last-minute birthday gift for your girlfriend. The gift was worth it, but when you manage to make the rent payment five days later, your property manager informs you that you also owe a $35 NSF fee, in addition to $20/day of late charges. You ask if they can make an exception for you. They say no, despite you thoroughly explaining that you needed to buy the birthday gift because your girlfriend would not have been happy if you had forgotten her birthday… again. “Sorry,” they say, “You agreed to those charges. It’s in your lease.” If this were a loan, the APR would be 1,077%!
“Overdraft? More like, I’m ‘over’ this!”
- In 2014, the CFPB released a report about overdraft services for debit card and ATM transactions. The study found that the majority of debit card overdraft fees are incurred on transactions of $24 or less and that the majority of overdrafts are repaid within three days. If this were a loan, the APR would be 17,000%!
In the examples above, your utilities company, landlord, and bank do not necessarily disclose the fees in terms of APR. However, once you begin thinking about these things in terms of APR, you appreciate how expensive they truly are! You may also realize that taking out a Payday Loan, Signature Loan, or Installment Loan to cover the costs described above might be cheaper than incurring late fees, reconnect fees, bounced check charges, and/or overdraft fees.
These examples also point out some of the limitations of using an APR.
First of all, some of these scenarios involve borrowing equivalents that are not required to be disclosed as an APR. Let’s examine the overdraft example. If your account has an overdraft feature, your bank will cover a purchase even if you don’t have funds in your account, and “collect” the amount it advanced to you the next time funds are deposited into the account – all in exchange for an overdraft fee, which could be as high as $35 dollars per covered transaction. Hmm… sounds like a loan, doesn’t it? But despite the similarities, overdraft fees are not required to be disclosed as an APR, so you may not be able to “compare” them by using an APR with very similar transactions… like a payday loan. So, the first limitation of APRs is that they are not uniformly required in all situations in which the substance of the transaction is the functional equivalent of a loan. For this reason, APRs are less useful than they otherwise might be. Don’t you just wish everything you have to pay for came with a percentage?
A second limitation is inherent in the underlying assumption of an APR calculation, namely that the loan will be outstanding over the course of an entire year. And… we’ve already talked (a lot) about that, as well as the fact that when the loan term is shorter, the APR can seem really high. So the second limitation to an APR calculation is that it doesn’t necessarily tell you very much about how much you will actually pay for your loan. Taking a full year to pay back a couple bucks doesn’t seem too realistic, right? As we have seen, a lower APR does not necessarily translate into a better deal.
The final limitation of an APR is that it may not take into account the value you might place on any given loan feature including fee structure and timing and method of repayment. For example, many people find that payday loans are easier to manage than other forms of credit because many payday loan products carry a flat fee that does not increase irrespective of when the loan is repaid (subject of course to default and late payment fees). Talk about keeping things casual and uncomplicated! This fee structure helps many people manage their borrowing and is simple to keep track of because the loan does not “accrue” interest over time. No interest? We’re definitely interested! Want more info on some of the wonders of payday loans? Check out our article setting straight five common misconceptions about payday loans.
There you have it—three surprising FYIs about APRs. One thing that should never be a surprise is what your APR is when you take out a loan. At Moneytree, each loan agreement will clearly lay out the APR, Amount of the Finance Charge, the Amount of the Loan, and the Amount of the Total Payments, for you to review before you sign the agreement. We believe in full transparency, no surprises, and in you doing what is the best for you. For more information about our loan products, visit us online or find your nearest Branch.
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