Annual percentage rate (APR) definition
a rate taking into account all costs associated with borrowed funds, which represents the full cost of loans
Annual percentage rate explained
Financial institutions provide quotes for interest rates and APR for their loans and other similar products. The borrower then compares different loans and decides which one will be cheaper. For the comparison to be valid and accurate, it should be made using the annual percentage rate.
The interest rate is the price a borrower pays for using the borrowed (principal) amount, but does not include any additional fees. On the other hand, APR takes into account the interest rate and all additional costs associated with the loan. Hence, it represents the true cost of the borrowed funds. It is especially important because some financial products can bear an extremely low interest rate but have high additional costs (fees and charges). Therefore, even with low interest rates, the overall cost of a loan could be much higher.
As the name suggests, the annual percentage rate is stated on a yearly basis. It is a superior rate for making comparisons because interest rates do not account for additional costs. With APR, different costs which are charged by the financial institution are included in the calculation of the APR. Different types of loans have different fees and charges. Fees included in the APR calculation are document processing fees, appraisal fees, underwriting fees, origination fees, as well as other loan-specific fees. When selecting a loan using the APR, a borrower should choose the one with the lowest APR. This would mean that the selected loan has the lowest cost compared to the other loans.
Types of APR
Fixed APR is a rate which remains the same during the life of the loan. This type of APR is preferred in time of economic distress because it locks in the cost of the loan, therefore eliminating the risk of a potential increase in interest rates and APR. Getting a loan with a fixed APR is advisable in periods when interest rates in the economy are low. Also, a loan with a fixed APR should be taken if an increase in interest rates is expected.
Variable APR is adjusted in accordance with changes in market interest rates. If there is a downward trend regarding future interest rates, a loan with a variable APR is beneficial to the borrower. That is to say, with decreasing interest, the APR will also decrease in the future. Consequently, the loan will become cheaper.