Personal Finance: Understanding APR

Personal Finance: Understanding APR

If you’ve ever been puzzled by the difference between interest rate and APR, you’re in the right place. For an explanation of why “Love After Lockup” is still on TV, consult the Oracle of Delphi.

The annual percentage rate is the effective annual interest rate on a loan including most ancillary charges and origination costs in addition to simple loan interest. The 1968 Truth in Lending Act established an obligation on the part of lenders to disclose this defined rate to assist consumers in accurately comparing loan offers with differing terms.

The most obvious example is in mortgage lending. Mortgage interest rates for a 30-year loan to borrowers with good credit are still close to 4%. This is the “nominal” rate applied to the amount outstanding on the loan each month. But home loans carry additional costs, including origination and underwriting fees, legal expenses, broker fees and discount points. The APR wraps these fees into the loan and presents the true annualized cost. This allows buyers to accurately compare, say, a 4.2% mortgage with zero points against a 3.9% loan with 1.5 points. Lenders are also required to compute the total of all payments over the life of the mortgage.

The same principle applies to car loans. The nominal rate understates the total cost of credit; the APR takes all additional loan fees into account and provides a tool for apples-to-apples comparison.

Beginning in the 1980s, many auto companies discovered an end run around disclosure of the true APR. Low interest or “0%” loans became common, suggesting to buyers the availability of below-market financing rates. Of course in reality, the imputed finance charge is rolled into the purchase price of the vehicle. By holding the total of payments constant but increasing the car price, the disclosed interest rate appeared artificially low. A cash buyer would enjoy a lower price since there are no hidden finance charges.

Credit card issuers are also required to inform customers of the APR in carried balances. Cardholders can pay off the balance before the next statement date without incurring additional charges. But unpaid balances are subject to interest, which can be quite high. According to Federal Reserve data, the average interest rate is 15%, the highest level in 25 years despite the historically low level of interest rates in general and Treasury bond yields in particular. Depending upon your credit score and income, APRs on bank cards range from 0% (usually an introductory rate) to more than 25% per annum. That highlights the imperative of paying down the full balance each month.

It should also be noted that there may be multiple APRs disclosed on your card statement. In addition to introductory rates, cards may be subject to different APRs for balance transfers, cash advances, and late fees and penalties.

The disclosure of the APR also makes it easier for consumers to evaluate short-term loans of less than one year. In particular, unsecured consumer financing like payday loans carry short repayment periods (a month or less), so the nominal or stated interest rate can be misleading. Consider a two-week loan of $100 that costs $15 to obtain. The nominal rate here would be 15%, which may not sound exorbitant. But annualizing this transaction actually results in an APR of more than 390%. Lenders are required to disclose this APR, but few borrowers truly understand it.

In short, when considering financing, look to the APR to provide a comparable base for evaluation and comparison among different lenders and aim to minimize it.

Christopher A. Hopkins, CFA
Vice President and Portfolio Manager
Barnett & Company

Chris Hopkins

Chris Hopkins, CFA, is Vice President and Portfolio Manager for Barnett & Company. He is a native of Whittier, California and has lived in Chattanooga since 1988. He began his career in finance in 1998, following twenty years in manufacturing management. Chris joined Barnett & Company in 2004. He served for twelve years an adjunct professor of Finance at UTC, and writes a weekly column for the Chattanooga Times Free Press on finance and economics. He is currently president of the CFA Society of East Tennessee, and is a member of the North Carolina and South Carolina CFA Societies as well as the National Association for Business Economics. He presently serves as city council representative on the Chattanooga fire and police pension board, and is member of the finance committee for the AIM Center. Chris holds the Chartered Financial Analyst (CFA) professional designation. He received Bachelor’s degrees in Physics and Economics from California State University at Fullerton, and earned his MBA from the University of Tennessee at Chattanooga.
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