What is APR on a Loan?
When you’re on the hunt for a loan, it’s safe to say that you’ll encounter a lot of new terminology.
One such term used in the world of personal finance is Annual Percentage Rate, or APR for short. However, what does it really mean for you as a would-be borrower?
We’ll investigate the ins and outs of APR to help you navigate the process of deciding on the right loan for you.
What is loan APR?
APR stands for Annual Percentage Rate.
It’s designed to calculate the total cost of borrowing money over the span of a year. In most cases, APR is expressed as a percentage, so it’s nice and easy to understand.
Unlike a lot of other numbers you’ll see flying around during your search for a loan, the APR is a relatively comprehensive figure which includes both interest rate, as well as some additional charges associated with borrowing the sum of cash you’re after.
When you sign up for a loan, the lender will typically charge you interest on the amount you’ve been given.
However, it’s likely that there’ll also be other costs involved too, such as setup fees or administration costs.
The APR figure for each loan will take into account each and every cost you’ll be expected to front if you accept the loan.
As you can imagine, the APR gives you a much more accurate picture of the overall cost of the loan you’re pursuing than any other figure could.
For the sake of transparency, all lenders are legally required to tell you what the APR is for a loan before you sign a credit agreement.
This helps keep you in the know at all stages of the process.
The APR is also vitally important to consider when you’re comparing loans from different lenders.
This is because it enables you to compare the total cost of borrowing, and work this into your budget hypothetically before officially signing a loan agreement.
By looking at the APR figure, you’ll also be able to determine which loan is more affordable, or which lender can offer you better terms. Generally, a lower APR reflects a lower cost of borrowing overall.
This is an extremely useful figure to have at hand as a would-be borrower.
However, it's worth noting that the APR is an annualised rate. This means that it represents the cost of borrowing over a single year.
However, the loan term you actually get could be shorter or longer than a year, depending on your needs.
So, if you have a loan with a term of six months, the APR still gives you a standardised way to compare the costs of different loans, but you may need to get your calculator out to discover the net cost of your borrowing.
Keep in mind that the APR figure doesn’t take anomalous factors such as prepayment penalties, variable rates of interest, or changes in the loan terms over time into account.
Therefore, it's really important to carefully review any terms and conditions a lender makes you aware of before making a decision.
Do all loans have an APR?
You may be surprised to know that not all loans come equipped with an APR.
Usually, an APR comes associated with credit products that carry interest as part of the arrangement. This includes things like personal loans, mortgages, car loans, and credit cards.
As you may already know, these types of loans involve borrowing money from a lender, and then paying it back with interest over a set time frame.
However, certain types of loans might not show an APR rate.
For example, payday loans and other short-term loans often charge a generic fee as opposed to interest, making the concept of an APR figure less relevant.
These types of loans are usually repaid within a shorter timeframe, say a few weeks to a month.
For this reason, the cost of borrowing under this type of arrangement is expressed as a monetary charge rather than an annualised rate.
Additionally, some loans on the market, such as interest-free loans or zero-interest offers, might not have an APR during their introductory period.
With this being said, it's important to look over the conditions of these loans, as they may incur other fees which could impact their cost overall.
What is a representative APR?
Now we’ve established what an APR is, you may be thinking you’ve got to the bottom of the term.
However, there’s another term which you should be mindful of when on the hunt for a loan: representative APR.
A representative APR is used by lenders to offer potential borrowers with an idea of the typical interest rate they offer on a particular loan product.
The clue as to what this APR signifies is in the word ‘representative’.
When a lender advertises a loan with a representative APR, it means that at least 51% of customers who take out this loan receive a rate that is equal to or lower than the representative APR displayed.
Of course, not everyone within the 51% bracket will necessarily get the same rate. However, it gives you assurance that over half of customers receive an APR of this level, or lower.
Some prospective borrowers quickly assume that the lender with the lowest representative APR you come across will offer them the best rate.
However, when you apply for a loan, it’s likely you’ll receive a personalised APR based on your circumstances and creditworthiness.
Naturally, this could be the same, higher, or lower than the representative APR that the lender advertises.
Lenders determine the interest rate they offer you based on a few different factors, including your creditworthiness, the stability of your income, and other risk metrics your lender will consider when reviewing your application.
When mulling over the prospect of applying for a loan, it’s wise to review the representative APR alongside other elements of borrowing such as fees you’ll need to cover, the repayment terms available, and the lender's reputation among past or existing customers.
This will help you to make a comprehensive evaluation of the loan you are trying to take out, and compare lenders effectively.
Are there any disadvantages of APR?
As useful as it is, the APR isn’t always a foolproof method of figuring out the total cost of borrowing. In fact, it can sometimes understate the actual cost of your loan depending on which lender you’re investigating when you come across the figure.
This is simply because the calculations that produce an APR assume that you’re going to enter a long-term repayment schedule for a loan.
The costs and fees are sometimes spread too thinly when an APR is worked out, and don’t account for loans which are repaid quickly, therefore incurring all the fees you owe to a lender in a shorter time frame.
For example, the average annual sum you’re going to need to spend on mortgage exit fees is much smaller when those costs are assumed to have been spread across 30 years, as opposed to say, 7 to 10 years.
Lenders also have a high degree of authority in determining how to calculate the APR on a loan product they’re selling. Sometimes, they include or exclude different fees and charges to make their offering seem more attractive, so beware!
APR can also be seen to run into issues on specific product offerings from lenders, including adjustable-rate mortgages, or ARM for short.
APR estimates always assume a consistent rate of interest being applied throughout the loan’s repayment term. Whilst it takes future changes in interest and mortgage rate caps into consideration, the final figure is still based on fixed rates.
Because the interest rate on an ARM will almost certainly change when the fixed-rate period comes to an end, APR estimates can understate the actual borrowing costs quite substantially if we consider the fact that mortgage rates will rise in the future.
Mortgage APRs are also less likely to include other charges you’ll need to cover for things like valuations, applications, insurance, lawyers, and document preparation.
In addition, there are other fees that sometimes crop up when buying a house that are deliberately excluded from the APR, including late fees and other one-off payment obligations.
All this uncertainty may mean it’s difficult to compare similar products to get the best deal if you solely rely on APR to project your outgoings.
This is because the fees included or excluded differ depending on which institution you’re researching at any given time.
To accurately compare multiple offers you find, you should determine which of the fees are included and, to ensure you understand what you’re entering into, calculate the APR for a product using the displayed interest rate and other information which you’ve got at hand regarding costs the lender might charge.
What’s the bottom line on APRs?
The APR is an estimate of the baseline cost of borrowing money from a lender.
By calculating a total sum of the interest rate and other costs, the APR gives you a snapshot of how much money you are going to need to shell out within a certain period of time.
If you’re borrowing money via products such as a credit card or a mortgage, the APR can be a bit misleading because it only represents the base sum of what you’re paying, without taking the factor of time spent paying the loan back into account.
APRs often form a selling point for different financial products offered on the market, such as mortgages or credit cards.
When choosing a borrowing route by comparing various APRs, be wary to also take into account any charges which are excluded from this rate.
A short phone call with a lender can often help iron out what these extra costs might be.