Talking about the cost of a loan or line of credit is confusing. You’ve probably heard terms like APR, interest rate, and flat rate fee thrown around all from different lenders. You’ve probably tried to compare APRs and looked for the lowest percentage that you can find. You’ve probably sought out lenders that say “no hidden fees,” and “no prepayment penalties!” might be something that has caught your eye as a benefit to you as a borrower. But what does all of this really mean and how should it be applied most productively as you decide which loan options you’re going to apply for?
APR stands for Annualized Percentage Rate and is the total annualized cost of borrowing. Depending on who you’re borrowing from, APRs will typically include all fees associated with the loan (for example, servicing and origination). APR differs from interest rate in that it is the annualized cost of the borrowed sum inclusive of other fees, while interest rates are annual costs associated with repayment of the borrowed sum and exclusive of other fees. Interests rates typically will also not include the associated fees discussed above. Both APR and interest rates use time as a mechanism of calculating cost. On the other hand, a flat rate fee is a non-variable, fixed fee that will remain the same over time. So for example, if you borrow $10,000 and your flat rate fee is 10%, you’ll owe back a total of $11,000 no matter how quickly or slowly you pay back the loan (unless of course there are other hidden fees associated - look out!) It is impossible to calculate what the APR or interest rate of a loan with a flat rate fee structure is unless you also know exactly how long it will take to repay that loan.
Calculating the APR of a loan can be easier than it may seem. You'll simply need three numbers: the amount borrowed, the fixed fee, and the term of the loan (how long it takes to pay back). To use a simple example, we can calculate the APR on a $1,000 payday loan with a $200 fixed feed and a 14-day term together. First, divide the fixed fee ($200) by the loan amount ($1,000). Next, multiply the result of the first step (0.2) by the number of days in the year (365). Then, divide the total from the second step (73) by the term of the loan in days (14). Finally, multiply the result by 100 and then add a percentage sign. The result: $200 / $1,000 x 365 /14 x 100 = 521.42%. Look at that APR! Often times the shorter the term of the loan is, the higher the APR will be.
Comparing APRs to interest rates to flat rate fees can get complicated because different lenders calculate the cost of borrowing in different ways. If you compare one lender’s APR, to another lender’s flat rate fee you may actually be comparing apples to oranges. Although with a flat rate fee, there is the luxury of knowing exactly what you’re going to pay - it could mean that depending on the variable of time (how quickly or slowly you pay back the total amount owed), your APR could skyrocket.
APRs also depend on the point in time that the calculation is being done. What does that mean? If you have a credit card that you pay off in full before it is due, using that credit card will cost you nothing (assuming there are annual fees). Alternatively, if you have a line of credit that you are continuously drawing on and you’re paying only your minimum payment, your interest will accrue over time based on how long you’ve drawn on the funds. If your APR has compounding interest, you’ll pay the percentage advertised for every day that you do not pay the money back. So, if you’ve made your minimum payment and you still have $1 leveraged on your credit card, you’ll pay interest on that one dollar today. Tomorrow, you’ll pay interest on that $1, plus whatever the interest was from the day before. This compounding structure continues for every day that you do not pay back the money you’ve borrowed, and can change your APR over time. Let's look at a graph of what this actually means over the course of a day, a month, and the entire year.
Another thing to be cautious of are credit cards that offer a 0% APR for a certain amount of time. Be sure to read the fine print on these credit cards because often times, in order to accommodate for the 0% APR cost, lenders will raise their APR when the 0% time frame is over.
Something that might help overall is considering your own behavior with your credit cards. Ask yourself questions like - do you often carry a balance on your credit card? Do you pay your minimum balance due, or are you able tot pay your credit card off in full each time a payment comes around? The cost of borrowing for you will depend on how much you dip into your available credit, and whether you’re able to cover that cost without paying any interest at all.
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