As you listen to discussions about home mortgages on T.V., shuffle through credit card offers you have received in the mail, or contemplate taking out a payday loan, you will no doubt be inundated with talk of APR's. APR's are a major factor in any financial decision, and when performing a transaction they ought be seriously and thoughtfully considered. But what exactly is an APR? In order to make a well-informed financial decision, one needs to have a better than vague notion of what an APR is and what it means for your loan, be it a car loan, house loan, or payday loan.
APR stands for Annual Percentage Rate, and is the percentage of the loan that one should expect to pay in interest in one year. There are two types of APR's: nominal APR's and effective APR's. Nominal APR's are the percentage rates one should expect to pay on the principle amount of the loan. For example, if the nominal APR on a loan of $100 is 15%, then you will pay $15 in interest rates in a one year period. This is the rate that is often given to borrowers when loan services advertise loans. Unfortunately, several factors play into a loan interest that make rates much more complicated, and thus the nominal APR is seldom the actual amount of money you can expect to pay on a loan. For this reason, there is a second APR definition which called the effective APR.
An effective APR is the actual amount of money you can expect to pay on a loan when considering all factors. These factors include fees and compound interest. The compound interest is interest added to the principle amount, thus gathering interest as well. For example, if you have the above loan of $100 and have accrued an extra $10 in interest, the $10 gets added to the total principle so that you now have $110 at a %15 percent rate, thus raising the amount of money you can expect to pay in a year by $1.50. Of course $1.50 is not a significant amount, but keep in mind that the higher the amount of the loan, the bigger the discrepancy will be between the nominal APR and the effective APR. A responsible payday lender will take time to explain all fees included in a payday loan or cash advance.
In addition to taking into account the compound interest, the effective APR will also take into account the fees that go with the loan. However, due to differences in state legislation the fees that the effective APR includes may vary depending on where you took out the loan. Some of the fees included in the effective APR may include monthly fees, late fees, upfront service fees, etc. The effective APR is calculated either by including the fees with the overall loan amount, by computing the interest on the fees separately from the interest on the loan principle, or by computing the interest of the principal alone, and then adding the fees to that amount.
While the exact nature of an APR confuses those who did not major in either mathematics or economy, by being aware of the general difference between a nominal Annual Percentage Rate and Effective Annual Percentage Rate you can make a better informed decision when applying for a loan of any kind, including everything from a home loan to a payday loan.
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