APR and The Real Cost of Borrowing
When you borrow money for a car loan, mortgage or other purchase or debt, one of your main concerns is what interest rate you will be charged. When entering into a loan agreement, it is important to understand that the interest rate is only one component of the cost of borrowing money.
While the interest charged is the largest expense, there are other “hidden” costs and fees that the borrower must incur such as closing costs, origination fees, insurance costs, etc. When looking at loan options, you may have seen the term “APR” which stands for Annual Percentage Rate.
The idea behind the APR is to disclose the total cost of borrowing once all these other hidden costs are included. By law, all financial institutions must show their customers the APR of a loan or credit card which clearly indicates the real cost of the loan.
It’s important to remember that the interest rates and APRs are not the same thing. If two loans charge the same interest rate but one has much higher fees, the APRs can end up being quite different. This is the whole point of lenders being required to disclose the APR – it provides a more accurate estimate of the real cost of a loan in a given year.
Sounds simple right? Just compare the APRs instead of posted interest rates and you’ll know what you’re dealing with. Unfortunately, it is not that easy.
Many car makers, credit card companies and banks try and confuse the consumer as much as possible. While some fees are required to be included in the APR of a loan, others are not. Simply comparing the APR of two loans may not tell you the whole story unless you ask what is and isn’t included in their calculations.
Furthermore, the advertised APR may be contingent on several different criteria that are not readily disclosed. A bank may offer a personal loan with an APR of four per cent but what they don’t make known is that the low rate is contingent on your acceptance of their life and disability insurance to protect them from default and the cost of this insurance isn’t included in the APR rate. To add further insult, the lender may then charge you three or four times the going market rate for this insurance with no easy way for you to be able to compare the insurance fees.
Even further confusing things is the fact that different countries calculate APRs in different ways. An “effective APR” takes compounding into account across a year where a “nominal APR” is the simple-interest rate for a year.
There is also marketing traps to beware of such as low introductory APRs that jump considerably after six months or multiple APRs (in the case of a credit card) decided by the type of transaction. These and many other hidden fine print items can cause you to pay far more interest than you ever expected and cause significant damage to your overall finances.
Borrowing money is a necessity for most people and is something the majority of Canadians will do countless times during the lives. But that doesn’t mean you should do it blindly.
The next time you are going to enter into one of these lending situations, take the time to fully understand the terms and conditions and what the total cost of borrowing that money will be. When in doubt, seek the guidance of a Certified Financial Planner professional who can help to fully explain and evaluate the different options with you.