When it comes to taking out a loan, financial experts warn you about interest rates. This term has been overused that people use both interest rates and APR (annual percentage rate) interchangeably, but both are different and the cost of the loan depends on the APR. When you are asked to compare deals, you should consider APR, not the interest rate only.
APR is a percentage of interest applied to a financial product that includes the cost of fees. Interest is an amount that a lender charges on top of the principal. It is a cost to borrowed funds. APR, on the other hand, includes fees that a lender will charge you to take out a loan. It means how much a loan will cost you over a course of year. Since APR adds in fees, it will always be higher than the interest rate.
The cost of a loan is always the interest that you pay on top of the principal. For instance, you have borrowed £1000 to be paid back along with £500. The cost of your loan is £500. It is essential that you consider the APR to determine the cost of the loan because fees vary from lender to lender.
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Types of APR
Non-variable and variable are two types of APRs.
- Non-variable APR – The former does not change throughout the loan term. You will know exactly how much you are going to pay in interest and fees over the course of one year. Borrowers generally prefer taking out loans with non-variable APRs as it makes budgeting easier. As you know how much you will pay in total, you can start setting aside that particular amount. If your lender will increase the interest rate, you will be notified. However, it happens only with a specific reason, not to just earn profits.
- Variable APR – The latter can change overtime. It mainly goes up and down according to fluctuations in prime rate. Lenders will not notify you about the change in interest rate. Prime rates fluctuation depends on the economic state. These rates can affect how much you will owe at the time of paying off the debt. A rise in interest rate will lead to arise in the total amount you will pack back to the lender. However, drop down will lead to a lower payment.
How does APR work?
If you borrow £5000 with an interest rate 20% and fees 5%, the APR will be 25%. It is important that you understand the concept of APR to estimate the total cost of a loan. Here is an example:
Case 1: when APR is 12%
Case 2: when APR is 24%
If you compare both tables, you will find that monthly payment shoots up as the APR hikes up. With 12% APR, the total cost of the loan will be £1,066.20 and with 24% APR, the total cost will go up to £1,134.72. Now you can easily see the difference.
However, the concept of APR does apply to 12 month loans uk only. It also plays a paramount role in case of short-term debts. For instance, imagine you have borrowed £200 to be paid back in 20 days. The total amount you will pay £232 assuming that the lender will charge 0.8% interest per day. It means you will pay £16 as interest on every £100.
If you miss your repayment, you will end up paying £280 because the interest will go up to £80 (£32 + £48). If you continue missing repayments for next three months, the due will hit £376 straightaway. This is how it can increase the cost of your debt.
Financial experts always suggest you that you should clear all of your dues on the due date because APR spirals up the debt. Whether you take out instalment loans or cash loans, the rollover will cause additional burden on your pocket.
How does amortisation affect APR?
Amortisation concept applies to larger loans that allow you to pay down interest along with the principal. Mortgages, personal loans and auto loans generally follow amortised feature.
Amortised loans come with two payment methods. The lender will allow you to choose any one of them according to your budget. These methods are equal total payment and equal principal payment method. Interest will go down with each instalment because your payment will go toward the principal too.
The role of APR in case of prepayment
Prepayment penalty is a fine that a lender imposes when you pay off a part or full loan. It is a percentage of the full cost of the loan. The rate of prepayment penalty varies from lender to lender. Look at the table below for more understanding:
|£1,000 (Assuming that you have paid equal total principal payment)
|£93.33 (£83.33 + £10)
|£92.50 (£83.33 + £9.17)
|£91.66 (£83.33 + £8.33)
Suppose that you have to pay down each instalment on last day of the month. You paid down first two instalments on time, but you paid down the third instalment before the scheduled date to save money in interest. In that case, you will also pay £150 (prepayment penalty) along with your third instalment.
The bottom line
The APR varies from lender to lender. When you take out a loan, you should consider both interest rates and APR. A sole decision based on lower interest rates can tie you up with a debt cycle. APR may include fees such as underwriting fees, loan origination fees, processing fees, documentation fees and credit check fees.