Personal Loans 101: UNDERSTANDING APR

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1 Personal Loans 101: UNDERSTANDING APR

2 In today s world, almost everyone needs access to credit. Whether it is to make a small purchase, pay for an unexpected emergency, repair the car or obtain a mortgage on your first home, everyone must have access to affordable credit. But how do you choose the best loan to fit your individual circumstances? If you are like most Americans, you want a loan that is relatively easy to obtain and understand. You do not want to go through a lengthy, complicated and confusing process to determine what loan or credit product best meets your needs. You want an easy way to compare them. 2

3 The Annual Percentage Rate, simply referred to as APR, is one factor you can consider when comparing loans. Looking at several factors will help you make an informed decision about what type of loan, interest rate and term best meets your needs. 3

4 What Is APR and How Is It Used? The government, through the Truth in Lending Act (TILA), developed APR to assist consumers when comparing loans. Annual Percentage Rate is the cost of credit expressed as a yearly percentage. Most people assume that the APR is equal to the annual interest rate, but APR includes the interest rate plus some of the costs involved in getting the loan as well as any annual fees. Some loan costs that could be included in the APR are loan origination fees or processing fees. APR is a very useful tool when comparing similar type loans that have similar terms. For example, the APR on a 30-year fixed rate mortgage allows you to evaluate and compare loans from various lenders, and APR can be very helpful when purchasing a new car with a 60-month loan. These are apples to apples comparisons APR is a very useful tool in these examples. However, it becomes much more difficult to compare different types of loans with different terms and fees based only on APR. Suddenly APR, which was designed as a comparison tool, can become misleading and confusing. For example, consider a $100 loan that must be repaid after one month for 5% interest plus a $10 origination fee. After 30 days, you would owe a total of $115 to the lender. The math is simple: $100 loan plus $5 interest plus $10 fee. However, the APR calculation gets a little more complicated. Without the $10 origination fee, this loan has an APR of 60%. However, if the onetime fee of $10 is considered, the APR jumps to 180%. Now to confuse the matter further, if this were a two-week loan for the same amount and fees, the APR would skyrocket to 360%. Without the origination fee, the APR would be 120%. For the first loan, the borrower paid $15 for the use of $100 for one month, and for the second loan the borrower paid $12.50 for the use of $100 for two weeks. These examples clearly show that considering only the APR does not tell a borrower the complete cost of credit. Let s look at a few everyday examples of consumer transactions converted to APR using the formula from the Truth in Lending Act (TILA) for calculating APR. 4

5 Product Finance Charge Amount Financed Repayment Period APR $1,000 Credit Card Balance: Minimum Monthly Payment = $30 $410 $1, Months 18% $1,000 Installment Loan: Monthly Payment = $133 $596 $1, Months 96.53% $350 Payday Loan: Finance Charge = $15 per $100 borrowed $50 $ days % $20,000 Automobile Purchase: Monthly Payment = $ $2,955 $20, Months (5 Years) 5% Renting a $20,000 Car: Daily Rental = $110 $550 $20,000 5 Days 200% Bouncing a $60 Check: Bank Fee = $35 Merchant Fee = $25 $60 $50 10 Days 4380% These examples show how typical purchases and credit products can appear very expensive when viewed only in terms of APR. 5

6 Calculating the True Cost and Value of Loans The Truth in Lending Act (TILA) requires that lenders tell borrowers a loan s: APR the annual cost of credit expressed as a percentage; Amount financed the dollar amount of credit provided to a borrower; Finance charge the total dollar cost of credit; and Total payments the total amount of money that will be paid over the loan term. These factors can change dramatically with different credit products. The amount borrowed and term (amount of time to pay it back) impact all four of these factors. Rules of Thumb: Smaller Loan = Higher APR. Larger Loan = Lower APR. Shorter Term = Higher APR. Longer Term = Lower APR. These rules of thumb explain why a $500 payday loan for two weeks has an APR of 450%, a $500 installment loan for 7 months has an APR of 117.5%, and a $225,000 mortgage for 30 years has an APR of 4%. Of course, other factors are involved in setting loan rates, but these are the basic principles to understanding the true cost of credit. A smaller loan borrowed over a shorter period will cost less in total dollars, but have a higher APR. Why? One major reason is because each loan costs the lender relatively the same, regardless of size. Lenders spend the same amount of time and resources to evaluate a borrower s ability to repay a loan for $2,000 or $20,000. The lender s fixed cost for a larger loan is a smaller percentage, or APR, because it is distributed over a larger amount of money, while the fixed cost of a smaller loan is distributed over a smaller amount of money and often a shorter time period. 6

7 Knowledge Check: Which costs more? 1) $2,000 loan with an APR of 100% to be repaid in 6 monthly payments of $437.02; or 2) $5,000 loan with an APR of 24% to be repaid in 24 monthly payments of $ Answer: The out-of-pocket costs, or finance charge, for the $5,000 loan is $1,344.53, which is more than twice the finance charge of $ for the $2,000 loan. However, the monthly payments ($437.02) will be greater for the $2,000 loan than for the $5,000 loan ($264.36) Does this mean that you should get a larger loan because the APR will be lower? Absolutely not. Although you might save on the APR, you should not borrow more money than you need. Remember, your total out-of-pocket cost can be much greater for a large loan paid over a long period of time. More importantly, in addition to the APR, you should look at your monthly payment and ask yourself: Is it affordable? Can I fit this amount in my monthly budget? Credit Scores and APR You should know your credit score because it can directly impact the APR you are charged for a loan. For many types of loans, borrowers with high credit scores get lower APRs than consumers with lower credit scores or poor credit histories. This is especially true for car loans. Your risk of default also impacts the interest rate you will be quoted for a mortgage or credit card. Traditional installment lenders do not rate their loans based on each customer s credit score, but turn down approximately 50% of borrowers for loans because of a poor credit report or lack of credit history. The lesson here is: know your credit score it can impact your APR and, in many cases, it is the deciding factor for whether you are approved or rejected for a loan. 7

8 Monthly Spending Worksheet Use the Monthly Spending Plan shown below to determine if you have enough income to cover your living expenses. The only time to take on a new monthly credit payment is when you are spending less each month than you take home. The additional debt load should not cut into the amount you have committed to saving. Monthly Take Home Saving TOTAL INCOME $ Monthly Expenses: Mortgage Payment/Rent Utilities Groceries/Lunches/Dinners Out Transportation Insurance (Home, Vehicle, Life) Taxes Clothing Personal Entertainment Gifts & Contributions Family Education Credit Card Payments Vehicle Payments Other Creditor Payments TOTAL EXPENSES TOTAL INCOME MINUS TOTAL EXPENSES = $ 8

9 Making Smart Credit Choices Everyone s financial situation is different, and you must consider your needs and responsibilities when choosing a loan and deciding if you even should take out a loan. Look at your current bills and income, and your current and future needs. Prepare a budget before taking out any loan to determine if you will have enough money available to repay it. Shop around for the best loan, and make sure you compare the monthly payment and total cost, in addition to the interest rate and APR. Do not let anyone pressure you into making a decision, make sure you understand the terms of the loan, and read all documents before signing them and make sure that no lines are left blank. Comparison Shopping Worksheet As you shop around for the loan that best meets your needs, use the Comparison Shopping Sheet below to fill in key information. Loan A Loan B Loan C Amount BoRrowed Monthly Payment Length of loan finance Charge APR Total payments 9

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