29 Dec Understanding APR: Why You Should Look Beyond the Headline Figure
The Annual Percentage Rate is a very important figure in personal finances, and it’s often cited as one of the best ways of comparing loans. In short, the APR should be able to tell you the interest you’re going to be paying each year in the life of the financial product you’ve taken out. In many countries, it’s a requirement for this to be displayed very clearly, as it can help consumers understand how much a loan actually costs. However, not all APR figures are equal, and in some cases, things can be a little misleading.
The first problem to be aware of is that there are actually three different ways APR can be calculated, which means you could have three different figures for the same loan. It may be up to you to find out which of the following it is, and this is very likely to depend on your country or jurisdiction.
- The simplest APR rate is calculated by compounding the interest for each year of the loan, not including any fees.
- The next, and most common, also includes the associated fees, and the interest is calculated from both these and the balance due.
- Finally, fees can be calculated as a short term loan within the first few payments, with the rest of the balance following.
Ultimately, you need to be aware of what the APR is actually including before you try to compare loans or indeed work out how much it’s going to cost you. There may well be hidden fees not included, which is why you may need to do more research. Using brokers is not always the answer either; you can’t be sure that they’re comparing the same APR rate either.
On the flip side, APR can be misleading for some short term loans that do not last a full year. In the UK for instance, all costs and fees must be included within the APR rate, including things like late payments. This has the effect of wildly inflating the figure of short term loans, because the APR shows what you’d be paying over a year, even if the loan is not intended for that length of borrowing.
To conclude, APR can indeed be a useful way of comparing loans, but only if you’re absolutely sure you know what it’s representing, and that the two products you are looking at are exactly the same in terms of thing like total amount and length.