Why use an APR?
There are many elements which contribute to the total charge you pay for a loan. The interest rate is an obvious one, but there are many others, see below. In addition, loans work in many different ways with different terms and conditions. Taking all this together, it can be difficult to compare the cost of loans.
The solution to this is the APR. Essentially all the elements that contribute to the cost of a loan go into calculating the APR. The calculation itself is also standardised. The result is a simple figure that enables you to compare the cost of different loans.
To help you understand what an APR is, here are some examples:
Example 1: If you borrowed 1,755.30 for one year and at the end of the year you repaid 2,106.36.
- You will be paying an interest rate of 20%.
- The APR will also be 20%.
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Example 2: If you borrowed 1,755.30 for one year and at the end of the year you repaid 2,106.36 plus a loan administration fee of 175.53.
- You will still be paying an interest rate of 20%.
- The APR, however, will be 30%.
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Example 3: If you borrowed 1,755.30 for one year and paid throughout the year in equal monthly instalments (12 x 175.53 = 2,106.36).
- You will still be paying an interest rate of 20%.
- The APR however will be roughly 40%.
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Example 3 is more expensive because you are paying back the 1,755.30 gradually throughout the year. As you don't have the benefit of the full amount for the whole year, say, to have earned interest on it, this increases the cost to you, hence the higher APR.
The interest rate on all three examples is the same, so you cannot use this to compare the cost of the loans. You may have suspected (without looking at the APR) that example 2 would be more expensive than example 1 because of the 175.53 fee payable - but what about example 3?
Without looking at the APR would you have known that this loan is roughly twice as expensive as example 1 and a third more expensive than example 2 (an equivalent of doubling the loan administration fee on example 2)?
The APR includes important factors such as:
- the interest rate you must pay;
- how you repay the loan [length of loan agreement (or term), frequency and timing of instalment payments and amounts of each payment];
- certain fees associated with the loan; and
- certain compulsory insurance premiums (for example payment protection insurance).
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