If you’re getting a loan (mortgage, car, personal, etc), it’s always a good idea to shop around for the best deal and avoid to fall in costly traps. But how do you compare finance deals effectively? In this article we will:
- confirm what means APR
- do a loan simulation to validate how these numbers can mislead us
- understand why financial providers use the words “representative” or “typical” APRs
- learn to calculate APR on payday loans (to prove that you should stay far away from them)
- consider some aspects about compounding interest and APR for mortgages
Content that you will find in this article:
Bank traps when Choosing the best loans
Many borrowers only look at how much is needed to pay monthly, and if that fits their budget. This is a very important aspect, as you don’t want to commit to a payment plan that you cannot afford, but it is not the only thing to look in a loan. You also don’t want to be paying thousands and thousands more for a loan, just because you didn’t know how to compare deals.
Sadly many people fall on loan traps, for not understanding how payment plans work. It is shocking, but many actually ignore the Annual Percentage Rate (APR). On the other hand, some people might compare loans only based on APR comparisons, without considering other components of the payment plan. That strategy can lead you down the wrong path, and might ends on the borrower paying back much more in the end.
What is APR?
APR means Annual Percentage Rate. This is the amount of interest on your total loan amount that you’ll pay annually (averaged over the full term of the loan). A lower APR translates to lower monthly payments and are commonly used to describe the interest you need to pay on house loans (mortgages), car loans and many others.
Once you know your APR, you’ll roughly be able to work out the cost of borrowing. On a basic level, borrowing money at an APR of 10% means you’ll pay 10% of the amount that you borrow over a year plus the remaining credit amount.
However, the full amount you end up paying also depends on:
- how long it takes you to pay all the loan
- any additional fees included in the loan
In many cases, it makes the most sense to choose loans with a lower APR. However, sometimes a loan offer with a lower APR may require you to pay other fees. On the other hand, loans with higher APR may spread your debt along more years.
I’ve made a simulation here for you to understand how APR works in a practical example.
Imagine you need to take a loan of $ 120 000 and there are 3 banks in the market offering different deals for you:
- Ripoff Associates are offering you monthly instalments of: $ 1 300
- 3% APR
- no initial fee
- 10 years to pay
- Fair Deal Corp is offering you monthly instalments of: $ 1 628
- 2% APR
- 5 years to pay
- no initial fee
- Samaritan Bank is offering you monthly instalments of: $ 1 719
- 1% APR
- 7 years to pay
- 10 % initial fee (added to loan)
What is the best deal? Which one will cost you less?
At first sight, one might think that Ripoff Associates are offering the best deal, as they offer lower instalments. And Samaritan Bank deal seems madness with such higher monthly instalments.
And this is a common mistake…
It is surprising the amount of people that look at these numbers and consider only the monthly instalment or only the APR, to decide to take the loan or not, completely ignoring the total cost of it. In the end of the day, all the money will come out from the same pocket, therefore, if you want to be financially successful you need to know how to interpret deals and find which one is the best.
In this scenario, your payment plans are going to be:
- Interest per year: $120 000 x 3% APR = $ 3 600
- Interest for the entire loan: $2 400 annual interest x 10 years = $36 000
- Total cost of the loan: $0 fee + $36 000 of interest
- Total paid after 10 years: $120 000 loan + $36 000 cost of loan = $156 000
Fair Deal Corp
- Interest per year: $ 120 000 x 2% APR = $ 2 400
- Interest for the entire loan: $ 2 400 annual interest x 7 years = $16 800
- Total cost of the loan: no initial fee +$16 800 of interest
- Total paid after 5 years: $120 000 loan + $16 800 cost of loan + = $136 800
- Interest per year: $120 000 x 1% APR = $ 1 200
- Interest for the entire loan: $1 200 annual interest x 7 years = $ 8 400
- Total cost of the loan: $12 000 fee + $ 8 400 of interest
- Total paid after 7 years: $120 000 loan + $ 20 400 cost of loan = $144 400
Hopefully you’ve noticed that:
- Samaritan Bank has the lowest APR, but not the cheapest loan (because of the initial fee)
- Ripoff Associates have the lowest monthly instalment, but still they are the most expensive
- Fair Deal Corp doesn’t have the best APR, or either the lowest monthly instalment, but they certainly have the cheapest deal!
While the APR makes it easier to compare loans, you’ll want to weigh all of the factors involved in getting a loan. These include any fees and the time of the loan, but mostly, you should always use the “Total paid amount” as your main metric to decide which loan will cost you less!
Typical or representative
While APR is the rate that you will pay on any loan, how this number is advertised is slightly more complicated. APR is advertised as either a typical or representative APR.
A representative APR is what you are most likely to see on commercials for credit cards and loans, but beware, what you see is not always what you get. Unfortunately, it is quite common for people to apply and be offered a worse rate. When complaining, the finance provide might just find an excuse based on the person’s credit history.
Representative or typical APR refers to the rate that at least 51% of people who are accepted for that product will pay. Meaning up to 49% of people who take out that product may pay a higher APR than that advertised.
APR tells you what interest rate you pay, but it doesn’t include the effects of compounding – so you almost always pay more than the quoted APR. If you only make small (or minimum) payments on your credit card (as example), you’ll start paying interest not only on the money you borrowed, but you’ll also pay interest on the interest that was previously charged to you. This compounding effect can raise your cost of borrowing higher than you might think.
APR for mortgages
Although APR is heavily used for comparing mortgages, lenders can easily mislead you when calculating the true cost of the loan. You may or may not include some of the costs you’ll pay. For example, the initial loan fee, credit report fee, appraisal fees, and inspection fees may not be included in the APR quote. Since different lenders can charge different credit report fees, the APR comparison becomes less valuable.
APR on payday loans
Payday loans are notoriously expensive. These short-term loans might appear to have relatively low rates, but the fees make them problematic. Sometimes even the fees don’t seem terrible when you’re desperate: you might gladly pay $15 to get cash quickly in an emergency.
However, when you look at these costs in terms of an annual percentage rate, you’ll probably find that there are better ways to borrow.
Example: you’ll get a payday loan for $500, and you pay a fee of $50. The loan must be repaid within 14 days. What is the APR?
The Consumer Federation of America explains how to calculate the APR on a short-term payday loan:
- Divide the finance charge by the loan amount ($50 divided by $500 equals .01)
- Multiply the result by 365 (.01 multiplied by 365 equals 36.5)
- Divide the result by the term of the loan (36.5 divided by 14 equals 2.6071)
- Multiply the result by 100 (2.6071 multiplied by 100 equals 260.71% APR)
260.71% APR means that you would be paying ($ 500 x 260% = ) $ 1800 if the debt is not settled in a year.
If you want to find the best loan, take a look at each lender’s quote closely. Don’t be deluded by monthly instalment figures neither promises of low interest. Look at the rate and total costs of the loan – not just the APR – and note carefully which costs are excluded.
Build a little spreadsheet to get yourself a true comparison between different finance providers before committing to any payment plan.
Entrepreneur, real estate investor and occasional trader.
“If you don’t find a way to make money while you sleep, you will work until you die.” -Warren Buffett