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Course: Financial Literacy > Unit 5
Lesson 3: Terms of borrowingWhat is APR and why does it matter?
Knowing about Annual Percentage Rate (APR) and how it affects loans is really important for making smart choices when borrowing money. This helps people stay in control of their finances and avoid paying too much in interest.
How credit can be useful and risky
Credit is when you borrow money from someone or a company, and promise to pay it back later with some extra money. The extra money is called interest, and it is the cost of borrowing.
Credit can be useful when you need to pay for something important, like education, a car, or a house, and you don't have enough money saved up.
Credit can also help you build a good credit history, which shows that you are responsible and trustworthy with money. This can help you get better credit terms in the future, such as lower interest rates or higher credit limits.
However, credit can also be risky if you borrow more than you can afford, or if you don't pay back on time. If you miss a payment or pay late, you may have to pay extra fees or penalties, which can increase the interest and the total amount you owe. This can hurt your credit score, which is a number that reflects how well you manage your credit. A low credit score can make it harder to get credit or other financial services, such as insurance, renting, or utilities.
If you don't pay back your credit at all, you may face legal action or lose your property that you used as .
Factors that affect the cost of borrowing
The cost of borrowing depends on several factors, such as:
- The interest rate, which is the percentage of the amount you borrow that you have to pay as interest. The higher the interest rate, the more expensive the credit is.
- The principal, which is the amount you borrow. The higher the principal, the more interest you have to pay.
- The term, which is how long you have to pay back the credit. The longer the term, the more interest you have to pay.
To compare the cost of different credit options, you can use a concept called APR, which stands for annual percentage rate. APR is the interest rate plus any other fees or charges that you have to pay for the credit in a year. APR shows you the true cost of borrowing, and it helps you shop around for the best deal.
Typical APR ranges
There are many types of credit sources that you can use for different purposes.
| Credit source | Interest rate range |
|---|---|
| Credit cards | |
| Mortgage loans | |
| Auto loans | |
| Personal loans | |
| Payday loans |
You will notice that APR varies depending on what type of loan you are applying for. For example, credit cards typically charge higher interest rates than mortgage or auto loans. This is because credit card loans are typically unsecured, meaning that the lender does not have any collateral to take if the borrower defaults on the loan.
Mortgage and auto loans, on the other hand, are secured by the property or vehicle that is being financed, so the lender has the option to repossess the property or vehicle if the borrower does not make their payments. Because of this, mortgage and auto loans are seen as less risky for the lender, and therefore they typically charge lower interest rates.
The rates themselves have a wide range (such as personal loans
APR: How it's calculated and the types
APR is calculated by dividing the total amount of interest and fees that you have to pay for the credit in a year by the average balance that you owe.
APR includes the interest rate and any other fees or charges that are mandatory or upfront, such as , , or annual fees. APR does not include any taxes, insurance, or charges that are optional or , such as late payment, cash advance, balance transfer, or prepayment fees. APR also does not include any benefits or discounts that may reduce the cost of borrowing, such as rewards or cash back.
There are two types of APR that you may encounter: nominal and effective.
Nominal APR is the interest rate that does not account for the compounding frequency, which is how often the interest is calculated and added to the balance. Nominal APR is what is typically listed on your loan application and statements.
Effective APR is the interest rate that does account for the compounding frequency, and shows you the actual interest cost. The more frequently the interest is compounded, the higher the effective APR. For example, if you borrow
However, if you borrow the same amount with the same nominal APR but a daily compounding frequency, you will pay
Additional APR terminology
There are several other terms you should be aware of when it comes to APR. These include fixed versus variable interest rates, grace periods, and additional fees, such as late payment, cash advance, and prepayment penalties.
A fixed interest rate stays the same for the entire term of the loan, while a variable interest rate can change based on market conditions.
A grace period refers to the amount of time given to the borrower before any payments are to be made, or any fees, or penalties are added. It gives borrowers an extra window of time to make their payment without being penalized. In case of credit cards, it is period of time before interest gets added to the balance.
A late payment fee is charged when you don't pay your bill on time. A cash advance fee happens when you use your credit card to get cash, like at an ATM. Prepayment penalties are fees you might have to pay if you pay off a loan earlier than expected.
Additional fees can add to the cost of borrowing, so it's important to be aware of them and try to avoid them if possible.
Conclusion
When you're in the market for credit, be sure to shop around for the best APR. Don't just look at the interest rate, but take into account any fees that might be associated with the loan as well. The APR is arguably the best way to compare apples to apples when it comes to credit, so use it to your advantage.
Finally, before signing any loan agreement, read the fine print carefully and ask about any hidden fees or penalties. Being an educated borrower will save you time and money in the long run.
Want to join the conversation?
Two questions.
1. What are "Questions" and "Tips & Thanks" not yet available on Khan Academy's mobile app?
2. Is repaying a loan earlier than the set time not good? Why then is there a prepayment fee?(10 votes)
If you pay off the loan earlier than expected, the lender is unable to collect more interest long term, resulting in fees to incentivize you to pay it off long-term.(11 votes)
So, from what i understand: what apr is trying to do here is to calculate the actual interest rate right? I mean by including any associated fee stuff into the interest, so you have an idea of the actual interest or well the total extra amount you gotta give back?(7 votes)
Your confusion is EXACTLY why the US government mandated, some years ago, that lenders compute and publish the Annual Percentage Rate, so that consumers could compare lenders and loan products to each other on a level playing ground. You've got to pay back the full amount of the loan you take, plus any fees for getting the loan, plus the interest that the lender asks for letting you use their money.
If you consider taking a loan as comparable to renting a house, the interest is the "monthly rent" on the money that you're using.(11 votes)
How come paying off a loan early leads to penalties? I thought it would be a good thing and add on to your credit score.(4 votes)
Lenders make money off of interest. If you pay off your loan 6 months sooner than the contract end date, then that lender misses the potential interest they would've received for the remaining 6 months. Hence the fees. Not all loans will penalize you. It depends on the terms of your contract.
As for early pay off being a good thing for your credit score...I don't know. One credit advisor from CK said that having a history of on time payments does more for your credit than one large payment.(3 votes)
- What math was done to get an APR of 12.68% and then 12.75%?(5 votes)
The formula for compound interest is A = P(1 + r/n)^nt. A stands for the amount, P stands for principal (initial amount loaned), r is the interest rate as a decimal), n is the number of times interest is compounded per year, and t is time in years.
The first thing we are going to do is convert the 12% rate to a decimal, so r = 0.12.
To get 12.68%, we start with P = 100, r = 0.12, and n = 12 (because there are 12 months in a year), so A = 100(1 + .12/12)^(12*1) = $112.68.
To get 12.75%, we start with P = 100, r = 0.12, and n = 365 (because there are 365 days in a year), so A = 100(1 + .12/365)^(365*1) = $112.75.(1 vote)
For anyone who wants to see how the math works for APR and compound interest here is the formula A = P(1 + r/n)nt. Working through the problems helped me understand it more.(5 votes)
Is there any examples of hidden fees or penalties in loan agreements?(2 votes)- A "loan fee" is not usually hidden, nor is a "late payment" fee or "early payment" fee. These are pretty obvious. Other fees are usually stated clearly in the loan agreement that you sign. Penalties are typically out front and readable (at least, in the USA where simple language is required). Of course, if you are operating in a different legal environment, or outside the law, things could be different. So, READ the contract. Have someone else read it with you.(5 votes)
Could you give an example as to how the APR formula can be used?(2 votes)- The most common use I have for the APR formula (for which I thank the US Government which requires lenders to post it) is to compare the kinds of places from which I might borrow money. The formula makes it possible to compare the cost of borrowing from different banks, credit unions, mortgage lenders and "non-bank" lenders.
By comparing the legally required APR information from one of these to the others, I can quickly see which source of a loan will work out better for me.(2 votes)
- good eye did great time do it the maney(1 vote)
- So, from what i understand: what apr is trying to do here is to calculate the actual interest rate right? I mean by including any associated fee stuff into the interest, so you have an idea of the actual interest or well the total extra amount you gotta give back?(0 votes)
- The declaration of APR is certainly about PART of that. It gives you an opportunity to compare two different loan products on an even ground, but that applies to the interest alone. Other fees are not part of APR.(0 votes)